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Fractional-reserve banking is the practice whereby banks retain only a portion of their customers' deposits as readily available reserves (currency or deposits at the central bank) from which to satisfy demands for payment. The remainder of customer-deposited funds are used to fund investments or loans the bank makes to other customers.^[1] Most of these funds are later redeposited into banks, allowing further lending. Thus, fractional-reserve banking permits the money supply to grow to a multiple of the underlying reserves of base money originally created by the central bank.^[2][3]

Most central banks and other monetary authorities regulate bank credit creation, imposing reserve requirements and other capital adequacy ratios. This limits the amount of money creation that occurs in the commercial banking system,^[3] and ensures that banks have enough funds to meet the demand for withdrawals. To mitigate the risks of bank runs (when a large proportion of depositors seek withdrawal of their demand deposits at the same time) or, when problems are extreme and widespread, systemic crises, the governments of most countries regulate and oversee commercial banks, provide deposit insurance and act as lender of last resort to commercial banks.^[2][3]

Fractional-reserve banking is the current form of banking in all countries worldwide.^[4]

History

Fractional-reserve banking predates the existence of governmental monetary authorities and originated many centuries ago in bankers' realization that depositors generally do not all demand payment at the same time.^[5]

Savers looking to keep their valuables in safekeeping depositories deposited gold and silver at goldsmiths, receiving in exchange a note for their deposit (see Bank of Amsterdam). These notes gained acceptance as a medium of exchange for commercial transactions and thus became as an early form of circulating paper money.^[6]

As the notes were used directly in trade, the goldsmiths observed that people would not usually redeem all their notes at the same time, and they saw the opportunity to invest their coin reserves in interest-bearing loans and bills. This generated income for the goldsmiths but left them with more notes on issue than reserves with which to pay them. A process was started that altered the role of the goldsmiths from passive guardians of bullion, charging fees for safe storage, to interest-paying and interest-earning banks. Thus fractional-reserve banking was born.

However, if creditors (note holders of gold originally deposited) lost faith in the ability of a bank to [pay] their notes, many would try to redeem their notes at the same time. If in response a bank could not raise enough funds by calling in loans or selling bills, it either went into insolvency or defaulted on its notes. Such a situation is called a bank run and caused the demise of many early banks.^[6]

Starting in the late 1600s nations began to establish central banks which were given the legal power to set reserve requirements and to issue the reserve assets, or monetary base, in which form such reserves are required to be held.^[7] The reciprocal of the reserve requirement, called the money multiplier, limits the size to which the transactions in money supply may grow for a given level of reserves in the banking system. In order to mitigate the impact of bank failures and financial crises, governments created central banks – public (or semi-public) institutions that have the authority to centralize the storage of precious metal bullion amongst private banks to allow transfer of gold in case of bank runs, regulate commercial banks, impose reserve requirements, and act as lender-of-last-resort if any bank faced a bank run. The emergence of central banks reduced the risk of bank runs inherent in fractional-reserve banking and allowed the practice to continue as it does today.^[3][8]

Over time, economists, central banks, and governments have changed their views as to the policy variables which should be targeted by monetary authorities. These have included interest rates, reserve requirements, and various measures of the money supply and monetary base.

How it works

In most legal systems, a bank deposit is not a bailment. In other words, the funds deposited are no longer the property of the customer. The funds become the property of the bank, and the customer in turn receives an asset called a deposit account (a checking or savings account). That deposit account is a liability of the bank on the bank's books and on its balance sheet. Because the bank is authorized by law to make loans up to a multiple of its reserves, the bank's reserves on hand to satisfy payment of deposit liabilities amounts to only a fraction of the total which the bank is obligated to pay in satisfaction of its demand deposits.

Fractional-reserve banking ordinarily functions smoothly. Relatively few depositors demand payment at any given time, and banks maintain a buffer of reserves to cover depositors' cash withdrawals and other demands for funds. However, during a bank run or a generalized financial crisis, demands for withdrawal can exceed the bank's funding buffer, and the bank will be forced to raise additional reserves to avoid defaulting on its obligations. A bank can raise funds from additional borrowings (e.g., by borrowing in the interbank lending market or from the central bank), by selling assets, or by calling in short-term loans. If creditors are afraid that the bank is running out of reserves or is insolvent, they have an incentive to redeem their deposits as soon as possible before other depositors access the remaining reserves. Thus the fear of a bank run can actually precipitate the crisis.

Many of the practices of contemporary bank regulation and central banking, including centralized clearing of payments, central bank lending to member banks, regulatory auditing, and government-administered deposit insurance, are designed to prevent the occurrence of such bank runs.

Economic function

Fractional-reserve banking permits a bank to make loans against the reserves it takes in as demand deposits. Full-reserve banking would not permit lending from demand deposits. Fractional-reserve banks can thus offer demand accounts, which provide immediate liquidity to depositors, and also provide longer-term loans to borrowers, and act as financial intermediaries for those funds.^[3][9] Less liquid forms of deposit (such as time deposits) or riskier classes of financial assets (such as equities or long-term bonds) may lock up a depositor's wealth for a period of time, making it unavailable for use on demand. This "borrowing short, lending long," or maturity transformation function of fractional-reserve banking is a role that many economists consider to be an important function of the commercial banking system.^[10]

Additionally, according to macroeconomic theory, a well-regulated fractional-reserve bank system also benefits the economy by providing regulators with powerful tools for influencing the money supply and interest rates. Many economists believe that these should be adjusted by government to promote various public policy objectives.^[11]

Modern central banking allows banks to practice fractional-reserve banking with inter-bank business transactions with a reduced risk of bankruptcy. The process of fractional-reserve banking expands the money supply of the economy but also increases the risk that a bank cannot meet its depositor withdrawals.^[12][13]

Money creation process

There are two types of money in a fractional-reserve banking system operating with a central bank:^[14][15][16]

1. Central bank money: money created or adopted by the central bank regardless of its form – precious metals, commodity certificates, banknotes, coins, electronic money loaned to commercial banks, or anything else the central bank chooses as its form of money
2. Commercial bank money: demand deposits in the commercial banking system; sometimes referred to as "chequebook money"

When a deposit of central bank money is made at a commercial bank, the central bank money is removed from circulation and added to the commercial banks' reserves (it is no longer counted as part of M1 money supply). Simultaneously, an equal amount of new commercial bank money is created in the form of bank deposits. When a loan is made by the commercial bank (which keeps only a fraction of the central bank money as reserves), using the central bank money from the commercial bank's reserves, the m1 money supply expands by the size of the loan.^[3] This process is called "deposit multiplication".

Example of deposit multiplication

The table below displays the relending model of how loans are funded and how the money supply is affected. It also shows how central bank money is used to create commercial bank money from an initial deposit of $100 of central bank money. In the example, the initial deposit is lent out 10 times with a fractional-reserve rate of 20% to ultimately create $500 of commercial bank money (it is important to note that the 20% reserve rate used here is for ease of illustration, actual reserve requirements are usually a lot lower, for example around 3% in the USA and UK). Each successive bank involved in this process creates new commercial bank money on a diminishing portion of the original deposit of central bank money. This is because banks only lend out a portion of the central bank money deposited, in order to fulfill reserve requirements and to ensure that they always have enough reserves on hand to meet normal transaction demands.

The relending model begins when an initial $100 deposit of central bank money is made into Bank A. Bank A takes 20 percent of it, or $20, and sets it aside as reserves, and then loans out the remaining 80 percent, or $80. At this point, the money supply actually totals $180, not $100, because the bank has loaned out $80 of the central bank money, kept $20 of central bank money in reserve (not part of the money supply), and substituted a newly created $100 IOU claim for the depositor that acts equivalently to and can be implicitly redeemed for central bank money (the depositor can transfer it to another account, write a check on it, demand his cash back, etc.). These claims by depositors on banks are termed demand deposits or commercial bank money and are simply recorded in a bank's accounts as a liability (specifically, an IOU to the depositor). From a depositor's perspective, commercial bank money is equivalent to central bank money – it is impossible to tell the two forms of money apart unless a bank run occurs.^[3]

At this point in the relending model, Bank A now only has $20 of central bank money on its books. The loan recipient is holding $80 in central bank money, but he soon spends the $80. The receiver of that $80 then deposits it into Bank B. Bank B is now in the same situation as Bank A started with, except it has a deposit of $80 of central bank money instead of $100. Similar to Bank A, Bank B sets aside 20 percent of that $80, or $16, as reserves and lends out the remaining $64, increasing money supply by $64. As the process continues, more commercial bank money is created. To simplify the table, a different bank is used for each deposit. In the real world, the money a bank lends may end up in the same bank so that it then has more money to lend out.

The expansion of $100 of central bank money through fractional-reserve lending with a 20% reserve rate. $400 of commercial bank money is created virtually through loans.

Although no new money was physically created in addition to the initial $100 deposit, new commercial bank money is created through loans. The 2 boxes marked in red show the location of the original $100 deposit throughout the entire process. The total reserves plus the last deposit (or last loan, whichever is last) will always equal the original amount, which in this case is $100. As this process continues, more commercial bank money is created. The amounts in each step decrease towards a limit. If a graph is made showing the accumulation of deposits, one can see that the graph is curved and approaches a limit. This limit is the maximum amount of money that can be created with a given reserve rate. When the reserve rate is 20%, as in the example above, the maximum amount of total deposits that can be created is $500 and the maximum increase in the money supply is $400.

For an individual bank, the deposit is considered a liability whereas the loan it gives out and the reserves are considered assets. Deposits will always be equal to loans plus a bank's reserves, since loans and reserves are created from deposits. This is the basis for a bank's balance sheet. Fractional-reserve banking allows the money supply to expand or contract. Generally the expansion or contraction of the money supply is dictated by the balance between the rate of new loans being created and the rate of existing loans being repaid or defaulted on. The balance between these two rates can be influenced to some degree by actions of the central bank.

Money multiplier

The expansion of $100 through fractional-reserve banking with varying reserve requirements. Each curve approaches a limit. This limit is the value that the "money multiplier'" calculates.

The most common mechanism used to measure this increase in the money supply is typically called the "money multiplier". It calculates the maximum amount of money that an initial deposit can be expanded to with a given reserve ratio.

Formula

The money multiplier, m, is the inverse of the reserve requirement, R:^[17]

Example

For example, with the reserve ratio of 20 percent, this reserve ratio, R, can also be expressed as a fraction:

So then the money multiplier, m, will be calculated as:

This number is multiplied by the initial deposit to show the maximum amount of money it can be expanded to.

The money creation process is also affected by the currency drain ratio (the propensity of the public to hold banknotes rather than deposit them with a commercial bank), and the safety reserve ratio (excess reserves beyond the legal requirement that commercial banks voluntarily hold – usually a small amount). Data for "excess" reserves and vault cash are published regularly by the Federal Reserve in the United States.^[18] In practice, the actual money multiplier varies over time, and may be substantially lower than the theoretical maximum.^[19]

Money supplies around the world

Components of US money supply (currency, M1, M2, and M3) since 1959. In January 2007, the amount of "central bank money" was $750.5 billion while the amount of "commercial bank money" (in the M2 supply) was $6.33 trillion. M1 is currency plus demand deposits; M2 is M1 plus time deposits, savings deposits, and some money-market funds; and M3 is M2 plus large time deposits and other forms of money. The M3 data ends in 2006 because the federal reserve ceased reporting it.

Components of the euro money supply 1998–2007

Fractional-reserve banking determines the relationship between the amount of "central bank money" in the official money supply statistics and the total money supply. Most of the money in these systems is "commercial bank money". Fractional-reserve banking allows the creation of commercial bank money, which increases the money supply through the deposit creation multiplier. The issue of money through the banking system is a mechanism of monetary transmission, which a central bank can influence indirectly by raising or lowering interest rates (although banking regulations may also be adjusted to influence the money supply, depending on the circumstances).

This table gives an outline of the makeup of money supplies worldwide. Most of the money in any given money supply consists of commercial bank money.^[14] The value of commercial bank money is based on the fact that it can be exchanged freely at a bank for central bank money.^[14][15]

The actual increase in the money supply through this process may be lower, as (at each step) banks may choose to hold reserves in excess of the statutory minimum, borrowers may let some funds sit idle, and some members of the public may choose to hold cash, and there also may be delays or frictions in the lending process.^[20] Government regulations may also be used to limit the money creation process by preventing banks from giving out loans even though the reserve requirements have been fulfilled.^[21]

Regulation

Because the nature of fractional-reserve banking involves the possibility of bank runs, central banks have been created throughout the world to address these problems.^[8][22]

Central banks

Government controls and bank regulations related to fractional-reserve banking have generally been used to impose restrictive requirements on note issue and deposit taking on the one hand, and to provide relief from bankruptcy and creditor claims, and/or protect creditors with government funds, when banks defaulted on the other hand. Such measures have included:

1. Minimum required reserve ratios (RRRs)
2. Minimum capital ratios
3. Government bond deposit requirements for note issue
4. 100% Marginal Reserve requirements for note issue, such as the Bank Charter Act 1844 (UK)
5. Sanction on bank defaults and protection from creditors for many months or even years, and
6. Central bank support for distressed banks, and government guarantee funds for notes and deposits, both to counteract bank runs and to protect bank creditors.

Reserve requirements

The currently prevailing view of reserve requirements is that they are intended to prevent banks from:

1. generating too much money by making too many loans against the narrow money deposit base;
2. having a shortage of cash when large deposits are withdrawn (although the reserve is thought to be a legal minimum, it is understood that in a crisis or bank run, reserves may be made available on a temporary basis).

In practice, some central banks do not require reserves to be held, and in some countries that do, such as the USA and the EU they are not required to be held during the day when the banks are lending, and banks can borrow from other banks at near the central bank policy rate to ensure they have the necessary amount of required reserves by the close of business. Required reserves are therefore considered by some central bankers, monetary economists and textbooks to only play a very small role in limiting money creation in these countries. Most commentators agree however, that they help the banks have sufficient supplies of highly liquid assets, so that the system operates in an orderly fashion and maintains public confidence. The UK for example, which does not have required reserves, does have requirements that the banks keep a certain amount of cash, and in Australia while there are no reserve requirements, there are a variety of requirements to ensure the banks have a stabilising ratio of liquid assets, such as deposits held with local banks. Individual countries adhere to varying required reserve ratios which have changed over time.

In addition to reserve requirements, there are other required financial ratios that affect the amount of loans that a bank can fund. The capital requirement ratio is perhaps the most important of these other required ratios. When there are no mandatory reserve requirements, which are considered by some economists to restrict lending, the capital requirement ratio acts to prevent an infinite amount of bank lending.

Liquidity and capital management for a bank

To avoid defaulting on its obligations, the bank must maintain a minimal reserve ratio that it fixes in accordance with, notably, regulations and its liabilities. In practice this means that the bank sets a reserve ratio target and responds when the actual ratio falls below the target. Such response can be, for instance:

1. Selling or redeeming other assets, or securitization of illiquid assets,
2. Restricting investment in new loans,
3. Borrowing funds (whether repayable on demand or at a fixed maturity),
4. Issuing additional capital instruments, or
5. Reducing dividends.^{[citation needed]}

Because different funding options have different costs, and differ in reliability, banks maintain a stock of low cost and reliable sources of liquidity such as:

1. Demand deposits with other banks
2. High quality marketable debt securities
3. Committed lines of credit with other banks^{[citation needed]}

As with reserves, other sources of liquidity are managed with targets.

The ability of the bank to borrow money reliably and economically is crucial, which is why confidence in the bank's creditworthiness is important to its liquidity. This means that the bank needs to maintain adequate capitalisation and to effectively control its exposures to risk in order to continue its operations. If creditors doubt the bank's assets are worth more than its liabilities, all demand creditors have an incentive to demand payment immediately, causing a bank run to occur.^{[citation needed]}

Contemporary bank management methods for liquidity are based on maturity analysis of all the bank's assets and liabilities (off balance sheet exposures may also be included). Assets and liabilities are put into residual contractual maturity buckets such as 'on demand', 'less than 1 month', '2–3 months' etc. These residual contractual maturities may be adjusted to account for expected counter party behaviour such as early loan repayments due to borrowers refinancing and expected renewals of term deposits to give forecast cash flows. This analysis highlights any large future net outflows of cash and enables the bank to respond before they occur. Scenario analysis may also be conducted, depicting scenarios including stress scenarios such as a bank-specific crisis.^{[citation needed]}

Hypothetical example of a bank balance sheet and financial ratios

An example of fractional-reserve banking, and the calculation of the "reserve ratio" is shown in the balance sheet below:

In this example the cash reserves held by the bank is NZ$3010m (NZ$201m Cash + NZ$2809m Balance at Central Bank) and the Demand Deposits (liabilities) of the bank are NZ$25482m, for a cash reserve ratio of 11.81%.

Other financial ratios

The key financial ratio used to analyze fractional-reserve banks is the cash reserve ratio, which is the ratio of cash reserves to demand deposits. However, other important financial ratios are also used to analyze the bank's liquidity, financial strength, profitability etc.

For example the ANZ National Bank Limited balance sheet above gives the following financial ratios:

1. The cash reserve ratio is $3010m/$25482m, i.e. 11.81%.
2. The liquid assets reserve ratio is ($201m+$2809m+$1797m)/$25482m, i.e. 18.86%.
3. The equity capital ratio is $8703m/107787m, i.e. 8.07%.
4. The tangible equity ratio is ($8703m-$3297m)/107787m, i.e. 5.02%
5. The total capital ratio is ($8703m+$2062m)/$107787m, i.e. 9.99%.

It is very important how the term 'reserves' is defined for calculating the reserve ratio, as different definitions give different results. Other important financial ratios may require analysis of disclosures in other parts of the bank's financial statements. In particular, for liquidity risk, disclosures are incorporated into a note to the financial statements that provides maturity analysis of the bank's assets and liabilities and an explanation of how the bank manages its liquidity.

How the example bank manages its liquidity

The ANZ National Bank Limited explains its methods as:^{[citation needed]}

Liquidity risk is the risk that the Banking Group will encounter difficulties in meeting commitments associated with its financial liabilities, e.g. overnight deposits, current accounts, and maturing deposits; and future commitments e.g. loan draw-downs and guarantees. The Banking Group manages its exposure to liquidity risk by maintaining sufficient liquid funds to meet its commitments based on historical and forecast cash flow requirements.

The following maturity analysis of assets and liabilities has been prepared on the basis of the remaining period to contractual maturity as at the balance date. The majority of longer term loans and advances are housing loans, which are likely to be repaid earlier than their contractual terms. Deposits include substantial customer deposits that are repayable on demand. However, historical experience has shown such balances provide a stable source of long term funding for the Banking Group. When managing liquidity risks, the Banking Group adjusts this contractual profile for expected customer behaviour.

Criticisms

Critics of fractional-reserve banking and proposals for monetary reform have included economists such as Irving Fisher^[23] and Frank Knight.^[24] U.S. Congressman Ron Paul and Austrian School economist Murray Rothbard have identified fractional-reserve banking, central banking, and fiat currency as interdependent and destructive features of modern monetary systems.^[25][26] In Rothbard's analysis, the practice of fractional-reserve banking amounts to a form of fraud, embezzlement or legalized counterfeiting.^[27][28]