What Is Fractional Reserve Banking?

INTRODUCTION

Fractional-reserve banking is the most common form of banking practiced by commercial banks worldwide. It is a system in which only a fraction of bank deposits are backed by actual cash on hand. In this system, cash is available for withdrawal. The rest of the deposits that are accepted by the banks from the customers are given as loans to borrowers.

How Does It Work?

When a customer deposits money in their bank account, that money is no longer the depositor’s property, at least not directly. The bank now owns it, and in return, they give their customer a deposit account that they can draw on. This means the customer should have access to their full deposit amount upon demand. The full deposit is accessible only with established bank rules and procedures.

However, when the bank takes possession of the deposited money, it doesn’t hold on to the full amount. Instead, a small percentage of the deposit is reserved (a fractional reserve). This reserve amount typically ranges from 3% to 10%. The rest of the money is used to issue loans to other customers.

Increasing the reserve requirement takes money out of the economy whereas decreasing the reserve requirement puts money into the economy.

Working of the Economy

What if everyone who holds deposits in a certain bank decides to show up and withdraw all their money? This is known as a bank run. Since the bank is only required to hold up a small fraction of their customers’ deposits, it would likely cause the bank to fail due to an inability to meet their financial obligations.

For the fractional reserve banking system to work, depositors must not descend on the banks to withdraw all their deposits simultaneously. During the Great Depression in the 1930s, many U.S. banks were forced to shut down. Too many customers attempted to withdraw assets at the same time.

Since you now learnt about the reserve banking system during the Great Depression, here are a few more facts about The Great Depression of 1929

Advantages And Disadvantages

Fractional reserve banking has both advantages and disadvantages. It permits banks to use deposits that would be otherwise unused to generate returns in the form of interest rates on loans and also to make more money available to grow the economy. However, during a bank run, the bank may run out of cash and thus face sudden bankruptcy. Nevertheless, fractional reserve banking is an accepted business practice that is in use at banks worldwide.

Reserve Banking System

Conclusion

Just like any other system of banking, finance reserve banking too has its own positives and negatives, nevertheless, it is a legal and acceptable practice worldwide.


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