Why fractional reserve banking

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Overview of fractional reserve banking. Money creation in a fractional reserve system. Weaknesses of fractional reserve lending. Simple fractional reserve accounting part 1. Simple fractional reserve accounting part 2. Lesson summary: banking and the expansion of the money supply. Practice: Introduction to fractional reserve banking. Practice: The money multiplier and the expansion of the money supply. Next lesson. Current timeTotal duration Google Classroom Facebook Twitter. Video transcript What I want to do in this video is give an overview of how money is created in most market based economies, and even a little bit of a discussion of what really is money.

And we can go into much more depth in future videos. And I think in many videos I already have gone into a much more technical depth. In most market based economies right now there is a central bank, which is essentially the actor, they do many things. They often will be a regulatory agency as well. But their main role is to have the right to print money, and to put that money into circulation. And I'll rely heavily on the model of the US. That's hard to read. The central bank in some countries is formerly part of the government.

In other countries, it's pseudo-independent. In the US. It's more of the pseudo-independent flavor of a central bank, although obviously closely connected with the government. The US Federal Reserve, a lot of the leaders are appointed by the government.

It's excess profits go back to the government. And so obviously it has very close ties to the government. But when the central bank decides to print money, it literally can just create it. It could literally print physical money. Or it can create electronic money, which has the same exact effect.

So let's say the central bank, it goes out there and it goes out there and it prints three-- and we'll just focus on the physical right now. It's a little bit easier to conceptualize.

And it just goes out there and it prints three physical dollar bills. Now it has to figure out, how does it get it into circulation? How does it get it into the economy? And it does not just put it into a helicopter and drop it from that helicopter. Sometimes, in certain circumstances, it can lend to this directly to banks, certain types of banks, member banks. But the typical way that this enters circulation is that the central bank will use this newly created money, this newly created reserves I should say, to go out into the open market and buy securities.

And they typically buy very safe securities, typically government debt. So they will go out there and they will put this into circulation. Nevertheless, fractional reserve banking is an accepted business practice that is in use at banks worldwide. The Federal Reserve. Federal Reserve. Fiscal Policy. International Markets. Your Privacy Rights. To change or withdraw your consent choices for Investopedia. At any time, you can update your settings through the "EU Privacy" link at the bottom of any page.

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I Accept Show Purposes. Your Money. Personal Finance. Your Practice. Popular Courses. Personal Finance Banking. What Is Fractional Reserve Banking? Key Takeaways Banks are required to keep on hand a certain amount of the cash that depositors give them, but banks are not required to keep the entire amount on hand. Often, banks are required to keep some portion of deposits on hand, which is known as the bank's reserves. Some banks are exempt from holding reserves, but all banks are paid a rate of interest on reserves.

Fractional banking aims to expand the economy by freeing capital for lending. Article Sources. Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. Thus money is supplied at a lower resource cost, that is, with less labor and capital devoted to mining or importing precious metals and fashioning them into coins or bars.

Looking at the change in balance sheets from money warehouses to fractional reserve banks, the economy can now fund productive enterprises where before it only held metal. Gold can be exported, and productive machinery imported. Under a fiat money standard, as we have today with the Federal Reserve dollar, things are different. There are no mining or minting costs saved by holding fractional rather than percent reserves in the form of fiat money.

For commercial banks to hold percent reserves in the form of fiat money issued by the federal government would, however, change drastically the function of the banks. Instead of funding productive enterprises, the banks would instead only fund the federal government. Fewer loanable funds would be available to the private economy, and more to the government. Private investment would be suppressed, and public spending enlarged. At the moment, however, we are in an anomalous situation.

Banks are sitting on such vast quantities of excess reserves—paid to do so by the Federal Reserve as it pays a relative high interest rate on reserves—that the monetary base is larger than M1. Thus the U. Perhaps the leading leading argument made in favor of government regulation of banks is the argument claiming that a fractional-reserve banking system is inherently fragile and so needs deposit insurance. The argument rests on three underlying propositions:.

A run means that many depositors seek to withdraw at the same time, out of fear of a reduced payoff if they wait. A panic means that many banks suffer runs at the same time. My research into banking history convinces me that a and c are actually false, and even proposition b requires some qualification. A run is always possible against fractionally backed bank deposits that are unconditionally redeemable on demand.

Against such deposits, a run can even, in theory, be self justifying: If a run forces the bank to conduct a hasty sale of illiquid assets, the bank may receive such a reduced value for its assets that it becomes insolvent liabilities exceed assets , so that all depositors can no longer be paid in full. From this theoretical possibility, some economic theorists have jumped to the conclusion that fractional-reserve banks are in practice inherently run-prone.

The best known statement is a article by Douglas Diamond and Phillip Dybvig. But are real-world deposit contracts so fragile? Historical evidence says no. Please consider: If real-world deposit contracts really were as fragile as the self-justifying-run theory supposes, it would be a mystery how they survived centuries of Darwinian banking competition before the first government deposit insurance schemes began.

The theory of runs that better fits the historical record is that runs occur, not randomly, but when depositors receive bad news indicating that their bank might be already pre-run insolvent.

Receiving such news, depositors run because if assets are already be too small to pay all depositors back, the last in line get little or nothing. What makes a deposit contract run prone?

Assume that depositors are rational. This implies that the deposit is unconditionally redeemable on demand and that the bank pays on a first-come-first-served basis , and that default is likely on last claim serviced. To make an account non-run-prone it suffices to modify either one of these two conditions.

First, the deposit contract can make redemption conditional rather than unconditional. If withdrawals were too great for a bank to satisfy without suffering severe losses from hasty asset liquidation, the banker had the option to defer redemption for 60 or 90 days by requiring notice of intent to withdraw to be given that far in advance. More importantly, banks made default unlikely by providing their depositors with credible assurances that the bank would maintain solvency, that is, assets sufficient to pay in full even the last in line, even under adverse cir- cumstance.

To provide credible assurance, banks before deposit insurance held much higher capital than they do today, in the neighborhood of 20 percent. They invested much more conservatively, so that they faced much less risk of large asset losses. They avoided loans with high default risk, high risk of loss from interest-rate movements, and loans that were illiquid hard to resell. Banks that relied on demand deposits and banknotes did not make long-term fixed-rate housing loans, for example.

But few other countries have had similar experiences. It is therefore clear that run-proneness and panics are not inherent to fractional-reserve banking. If we look for a pattern across countries, this is what we find: Countries like Canada, Scotland, Sweden, and Switzerland, where the banking systems had no more than minimal restrictions on entry, note-issue, branching, and capitalization, had virtually no problem from runs and none from panics, in contrast to the more restricted and hence weaker banking systems of the United States and England.

The U. Branch banking limits reduced diversification of assets and deposit sources, indirectly limited capitalization, and hampered the effective allocation of reserves. Because of those restrictions, seasonal demands for currency became scrambles for reserve money that occasionally escalated into panics.

The weakness in the U. Today the weakness is due not to restrictions, but to privileges. One indication of that is that the weakest banks today are not the smallest, but the largest banking companies.

Federal deposit insurance, since its birth in the s, has meant that a comparatively risky bank one with capi- tal less adequate to cover potential losses on its asset portfolio no longer faces a penalty in the market for retail deposits.

Insured depositors have no incentive to shop around for a safe bank, so they no longer demand a higher interest rate to give it their deposits. Risk-taking is thereby effectively subsidized. Attempts to price deposit insur- ance according to risk, so as to recreate a penalty for holding on a risk bank portfolio, were mandated by the FDIC improvement act, but the attempt has failed. The FDIC insurance fund has been exhausted by bank failures, and now has a negative balance.