Home > Fractional-reserve banking
In economics, particularly in financial economics, fractional-reserve banking is the near-universal practice of banks of retaining only a fraction of their deposits to satisfy demands for withdrawals, lending the remainder at interest to obtain income that can be used to pay interest to depositors and provide profits for the banks' owners. Fractional-reserve banking allows for the possibility of a bank run in which the depositors collectively attempt to withdraw more money than is in the possession of the bank, leading to bankruptcy. This is possible because both the borrower and the depositor have a claim to withdraw money deposited at the bank. It also increases the money supply through a mechanism called the deposit creation multiplier, explained below, which leads to inflation by definition. Most governments impose strictly-enforced reserve requirements on banks, with the exact fraction of deposits that must be kept in reserve generally set by a central bank.Some political libertarians and some supporters of a gold standard use the term fractional-reserve banking for the practice of only partially backing a nation's currency with gold or other accepted stores of value, as occurred in various countries before the adoption of unbacked fiat money in most developed countries in 1971 with the collapse of the Bretton Woods Agreement. This usage is superficially similar to the standard usage in economics, in that the ability of a country to redeem only part of its currency in gold can be seen as analogous to the ability of a bank to redeem only part of its deposits in cash, but referring to partially-backed currencies as a form of fractional-reserve banking may create more confusion than it alleviates. Mainstream economists do not generally make this analogy.
1 Historical background
At one time, people deposited their precious metal valuables at goldsmiths, receiving in turn a note for their depositMain article deposit (bank A deposit is a specific sum of money taken and held on account, by a bank as a service provided for its clients. A financial institution wishing to take deposits are generally required be under financial supervision, and to hold. As these notes began to be used directly in tradingTrade centers on the exchange of goods and/or services. Exchanges may take place between two parties (bilateral trade) or amongst more than two parties (multilateral trade). In its original form trade necessarily used barter and the exchange of goods and, participants no longer needed to redeem their gold to perform the trade. Thus an early form of paper money was born.
As the notes were used directly for trade, the goldsmiths realized that people would never withdraw all their deposits at the same time. Thus goldsmiths saw the opportunity to issue new bank notes and lend them at interest—a process that altered their role from passive guardians of bullion to interest-earning (and interest-paying) banks. Here fractional-reserve banking was born. When creditors (the owners of the notes) lost faith in the ability of the bank to back up their note, they would try to redeem the note. This was called a run on the bank and many early banks either went broke or refused to pay up.
The process with which commercial banks practise fractional-reserve banking is explained at deposit creation multiplierA deposit creation multiplier measures the amount by which commercial banks increase the money supply. See fractional-reserve banking. Central banks generally restrict the proportion of primary deposits that commercial banks can lend out. This is called t.
The opposite of fractional reserve banking is full reserve banking, but this is not used in practice.
2 See also
- gold standard
- bimetallismIn economics, bimetallism is a monetary standard in which the value of the monetary unit can be expressed either with a certain amount of gold or with a certain amount of silver: the ratio between the two metals is fixed by law. This monetary system is ve
- Bretton Woods systemThe Bretton Woods system of international economic management established the rules for commercial and financial relations among the major industrial states. The Bretton Woods system was the first example of a fully negotiated monetary order in world hist
- Credit moneyCredit money is money that is backed by a promise to pay made by someone other than the state. Examples of credit money include bank deposits and credit card loans. During the Crusades in Europe, precious goods would be entrusted to the Catholic Church's
- Fiat money
- The Money Masters (A documentary on central banks and fractional-reserve banking in this context.)
