Understanding the Fractional Reserve Banking System

WHAT IS FRACTIONAL RESERVE BANKING AND WHY IT’S IMPORTANT

Amidst our discussion about divestment, it is helpful to understand the banking system and some of the relevant mechanisms of money. This explainer will cover the basics of the fractional reserve banking system and how divestment not only refers to your investments, but your checking account as well. This is just one part of the very complex banking and finance industry, but will hopefully provide useful context.

Fractional Reserve Banking

When you deposit money into your checking account, the bank gives you the ability to withdraw it at any time. However, the bank does not keep all of your deposit on hand in anticipation of withdrawal. Instead, it only has to keep some of the deposit and is free to use the rest. This is fractional reserve banking.

The reserve ratio is the proportion (typically 10%) of your deposit the bank must hold as reserves which can be readily withdrawn. For example, if you deposit $1000 the bank must hold $100 in reserves. (Of course this is scaled to the entire banking system and banks must hold 10% of all deposits they receive.)

So what happens to the other 90% of your deposit? The banks are free to lend out this money. Returning to our example, $900 of your $1000 could be loaned out. (There are other things banks can do instead of lending, but we’ll focus on lending for now since it is the most common example.)

Lending is meant to promote economic expansion, the idea being: more money is available to those who will use it to grow business, fund their projects, invest, etc. Why do banks lend? Most importantly to them, they make money from loans.

The notion of reserves can be very unintuitive at first and a common question is “how can banks promise withdrawal if only 10% of deposits are held as reserves?” Essentially, the entire system hinges on the assumption that not everyone will withdraw all of their funds at the same time or at least faster than the rate at which the banks can liquidate the loans back into reserves. This assumption has failed in the past when sentiment about a bank’s ability to provide owed deposits falters and a bank run occurs. A bank run is when people rush to withdraw their deposits at the same time and the banks don’t have the reserves and can’t give everyone their money. Bank runs can be significantly financially destructive and there have been prominent examples in the past and recently. However, modern policy and deposit insurance (provided in Canada by the Canadian government via the Canada Deposit Insurance Corporation) has helped to mitigate the damage and risk of bank runs. Crudely, as long as you and I don’t both try and withdraw our deposits at the same time, the reserves from my deposits can fund your withdrawals and vice versa.

Divestment

Divestment is the call to ensure the loans banks make with our deposits are toward sustainable projects and are not funding fossil fuels. Deposit insurance protects depositors from losing their money because of poor loaning on behalf of the banks. While important, an unintended consequence of this is that banks no longer have economic incentive to loan in ways to keep and attract clients by loaning responsibly. Banks profit off our money—if enough of their clients threaten to withdraw their funds, it may reinstate the pressure for them to lend and operate responsibly which includes divesting from fossil fuels.

Credit Unions are alternatives to commercial banks, although they still operate in a fractional reserve banking system. Credit unions are functionally very similar to commercial banks but may offer less services. However, joining a credit union means you become a part owner. This gives you voting rights on the operation of the credit union. As such, credit unions often don’t loan (or very little) to fossil fuel companies and with your voting rights, you can influence divestment.

This is for educational purposes only and is not financial advice. Please inform financial decisions based on your personal goals and own research. It is important to understand how your money moves and its influence. Hopefully this helped provide a better sense of the fractional reserve banking system and how divestment fits into all of it. If you have any further questions, please don’t hesitate to get in touch.

– Josh Der

[email protected]

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What is fractional reserve banking: reserve requirements

The Federal Reserve sets the reserve requirements for banks. This is the minimum percentage of deposits that must be retained in reserve. The money can be held in bank vaults as cash or deposited with Federal Reserve banks.

Up until 2020, the reserve requirement was 10% for banks holding over $124.2 million in assets. In other words, for every $100 deposited, the bank can lend $90. However, this was changed on March 26, 2020 when the Federal Reserve reduced the requirements to zero as a temporary measure to stimulate the pandemic-stricken economy.

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Characteristics of Fractional Reserve Banking (Pros Cons)

Pros

  • Allows banks to make money from deposits, thus relieving depositors of the necessity to pay the bank for safekeeping their money.
  • Allows banks to stimulate growth in the economy by lending capital to individuals and businesses.
  • Allows the Fed to regulate the money supply in the economy and ensure bank safety by modifying the reserve requirement.
  • Has a multiplier effect that essentially creates additional money from base deposits.

Cons

  • Can increase the risk of bank failure.
  • Concerns some economists that it can overheat the economy.

How Fractional-Reserve Banking Works

The supply of money grows when banks use funds held in accounts while simultaneously lending them out as loans. For example, when you deposit money into your account, the bank shows 100% of it in your account, but it is allowed to lend some of it to other customers. This acts to increase the amount of money in the economy.

To illustrate how it works, suppose you create a brand-new economy, and you add the first $1,000 to the system.

  1. You deposit $1,000 into a bank account. The system now has $1,000.
  2. You decide that banks can lend 90% of their holdings. The bank can then lend $900 to its other customers.
  3. Those customers borrow $900, and you still have $1,000 in your account, so the system has $1,900.
  4. Customers spend the $900 they borrowed, and the recipients of that money deposit $900 into their bank.
  5. That bank can lend out 90%, or $810, of the new $900 deposit.
  6. Customers borrow the $810. You still have $1,000 in your account, and the recipients of the first $900 still have that money available in their accounts. So the system now has $2,710 ($1,000 + $900 + $810).
  7. The cycle, known as the "money multiplier," continues.

Calculating Required Reserves for a Bank

Now let’s talk about calculating required reserves. Required reserves cannot be loaned out. For example, a required reserve ratio of 10% means that 10% of all demand deposits must be set aside on reserve. To figure out how much a bank has to reserve, you simply multiply the amount of their deposits by the required reserve ratio.

For example, with a required reserve ratio of 10%, and demand deposits of $20,000, the required reserves would be 10% x $20,000, which is $2,000. These reserves will not be held in the bank, they’ll be held at the Federal Reserve Bank.

Lesson Summary

Let’s summarize what we’ve learned in this lesson. The fractional reserve banking system is a system in which banks hold back a small fraction of their deposits in a reserve and loan out the rest of their deposits to borrowers.

The fractional reserve banking system legally permits banks to hold less than 100% of their deposits as a reserve. The required reserve ratio is the percentage of deposits that banks are required to reserve. To figure out how much a bank has to reserve, you simply multiply the amount of new deposits by the required reserve ratio.

Excess reserves are bank reserves above and beyond the reserve requirement set by a central bank. Excess reserves may be loaned out by the bank in order to generate profits. In the fractional reserve banking system, when a bank lends to a customer, this increases the money supply.

When a customer deposits money into a bank checking or savings account, this demand deposit is considered a liability to the bank, because they owe this money to the customer.

Understanding Fractional Reserve Banking

Banks are required to keep on hand and available for withdrawal a certain amount of the cash that depositors give them. If someone deposits $100, the bank can't lend out the entire amount.

Nor are banks required to keep the entire amount on hand. Many central banks have historically required banks under their purview to keep 10% of the deposit, referred to as reserves. This requirement is set in the U.S. by the Federal Reserve and is one of the central bank’s tools to implement monetary policy. Increasing the reserve requirement takes money out of the economy while decreasing the reserve requirement puts money into the economy.

Historically, the required reserve ratio on non-transaction accounts (such as CDs) is zero, while the requirement on transaction deposits (e.g., checking accounts) is 10 percent. Following recent efforts to stimulate economic growth, however, the Fed has reduced the reserve requirements to zero for transaction accounts as well.

The Bottom Line

Fractional reserve banking has pros and cons. It permits banks to use funds (the bulk of deposits) that would be otherwise unused to generate returns in the form of interest rates on loans—and to make more money available to grow the economy. It also, however, could catch a bank short in the self-perpetuating panic of a bank run.

Many U.S. banks were forced to shut down during the Great Depression because too many customers attempted to withdraw assets at the same time. Nevertheless, fractional reserve banking is an accepted business practice that is in use at banks worldwide.

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