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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.

Historical background

At one time, people deposited their precious metal valuables at goldsmiths, receiving in turn a note for their deposit. As these notes began to be used directly in trading, 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 multiplier.

The opposite of fractional reserve banking is full reserve banking, but this is not used in practice.

See also

• gold standard
• bimetallism
• Bretton Woods system
• Credit money
• Fiat money
• The Money Masters (A documentary on central banks and fractional-reserve banking in this context.)

Related topics

• list of economics topics
• list of finance topics
• list of business ethics, political economy, and philosophy of business topics

References

• Meigs, A.J. (1962), Free reserves and the money supply, Chicago, University of Chicago, 1962.
• Crick, W.F. (1927), The genesis of bank deposits, Economica, vol 7, 1927, pp 191-202.
• Philips, C.A. (1921), Bank Credit, New York, Macmillan, chapters 1-4, 1921,
• Thomson, P. (1956), Variations on a theme by Philips, American Economic Review vol 46, December 1956, pp. 965-970.