Economics
Fractional Reserve System
The fractional reserve system is a banking system in which banks are required to hold only a fraction of their deposit liabilities as reserves. This allows banks to lend out the majority of their deposits, creating new money in the form of credit. The system can lead to an expansion of the money supply and economic growth but also poses risks of bank runs and financial instability.
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9 Key excerpts on "Fractional Reserve System"
No longer available |Learn more- (Author)
- 2014(Publication Date)
- White Word Publications(Publisher)
____________________ WORLD TECHNOLOGIES ____________________ Chapter 4 Fractional-Reserve Banking Fractional-reserve banking is the banking practice in which only a fraction of a bank's deposits are kept as reserves (cash and other highly liquid assets) available for withdrawal. The bank lends out some or most of the deposited funds, while still allowing all deposits to be withdrawn upon demand. Fractional reserve banking is practiced by all modern commercial banks. When cash is deposited with a bank, only a fraction is retained as reserves and the remainder can be loaned out (or spent by the bank to buy securities). The money lent or spent in this way is subsequently deposited with another bank, creating new deposits and enabling new lending. The lending, re-depositing and re-lending of funds expands the money supply (cash and demand deposits) of a country. Due to the prevalence of fractional reserve banking, the broad money supply of most countries is a multiple larger than the amount of base money created by the country's central bank. This multiple (called the money multiplier) is determined by the reserve requirement or other financial ratio requirements imposed by financial regulators, and by the excess reserves kept by commercial banks. Central banks generally mandate reserve requirements that require banks to keep a minimum fraction of their demand deposits as cash reserves. This both limits the amount of money creation that occurs in the commercial banking system, and ensures that banks have enough ready cash to meet normal demand for withdrawals. Problems can arise, however, when depositors seek withdrawal of a large proportion of deposits at the same time; this can cause a bank run or, when problems are extreme and widespread, a systemic crisis.
eBook - ePubThe Triple Crisis of Western Capitalism
Democracy, Banking, and Currency
- T. Lauk(Author)
- 2014(Publication Date)
- Palgrave Macmillan(Publisher)
The other level of banking regulation consists of statutes passed by national parliaments. The Federal Reserve Act, passed by the US Congress one day before Christmas Eve 1913, may be regarded as the most influential banking law in the Western world. While substantial changes have been made to the Act over the years, the fundamental principle of the so-called fractional reserve banking system has survived unscathed.2.2 The fractional reserve banking principle – a hidden subsidy
Fractional reserve banking means that banks need only hold a fraction of their capital against customer deposits and assets like loans or derivatives. So if, for instance, Customer A puts USD 10,000 in his account with Bank A on day one, it only need be covered by 10 per cent of Bank A’s capital. The remaining USD 9,000 could be lent by the bank to Customer B. Nevertheless, Customer A could still withdraw his deposit on day two and receive his USD 10,000 in full. This is because during the course of history banks realized that during normal times no more than 10 per cent of bank customers withdraw their funds at the same time. Based on this empirical evidence they gradually adopted the fractional reserve principle.One point, however, needs to be highlighted: via the fractional reserve banking principle banks can increase the amount of money in circulation in an economy. As can be seen from the example, when Customer A withdrew his deposit of USD 10,000 right after Bank A made the loan of USD 9,000 to Customer B, the money supply increased by USD 9,000 because Customer A can spend his USD 10,000 while Customer B can spend his USD 9,000.If, however, Customer B puts the USD 9,000 into his account with Bank B, it again need only assign 10 per cent of its capital, or USD 900.If the two banks represent the banking system, the total required reserves amount to only USD 1,900: USD 1,000 in Bank A and USD 900 in Bank B. The remaining funds – USD 9,000 held by Bank A and USD 8,100 by Bank B, or USD 17,100 in total – are called ‘excess reserves’ and are available for loans and investments by those two banks, meaning that the additional USD 17,100 can be brought into circulation via more credit.
eBook - PDFSovereign Money
Beyond Reserve Banking
- Joseph Huber(Author)
- 2016(Publication Date)
- Palgrave Macmillan(Publisher)
70 Sovereign Money That which ultimately enables the fractionality of the reserve base is the fact that the velocity of reserve circulation is much higher than that of deposit circulation. The reserves involved in the process flow back and forth between the banks much more frequently (‘faster’) than the customers make use of the credits (bankmoney) in bank accounts. In a way that is the whole ‘secret’ behind cashless fractional reserve banking. In final result, and on statistical average, the total reserves the banks need for carrying out all current payments amount to only about 1.25 % of the stock of bankmoney in the UK, 17 about the same in the USA, and 1.5 % or slightly more in the euro area. In the euro area, the 1.5 %, or slightly above, include 0.02–0.04 % payment reserves (excess reserves) and 1.44–1.65 % cash in vault. In addition there is at present a rate of 1 % obligatory minimum reserves on all deposits subject to that requirement in the eurozone. This includes demand deposits, savings and time deposits. In the USA, the minimum reserve requirement is 10 % of deposits minus cash in vault, in Japan this is 0.81 %, in Switzerland 2 %. 18 In a number of countries there is—for good Fractional reserve theory is certainly misguided, and rightly rejected, when combined with the loanable funds model and identified with the multiplier model and the reserve position doctrine. Such a mish- mash, however, does not represent the entire spectrum of fractional reserve theory, as in fact the existence of fractional reserve circulation in connection with bankmoney circulation cannot be denied. Similarly, type (3)—credit creation out of nothing—is unspecific and incomplete. It is unspecific in that modern token fiat money, as it has no intrinsic value, is generally taken ‘out of thin air’, no matter whether it is about treasury coin, central bank notes and reserves or bankmoney.
eBook - PDF- Irvin Tucker(Author)
- 2018(Publication Date)
- Cengage Learning EMEA(Publisher)
Thus, goldsmith receipts became paper money. At first, the goldsmiths were very conservative and issued receipts exactly equal to the amount of gold stored in their vaults. However, some shrewd goldsmiths observed that net withdrawals in any period were only a fraction of all the gold “on reserve.” This observation produced a powerful idea. Goldsmiths discovered that they could make loans for more gold than they actually held in their vaults. As a result, goldsmiths made extra profit from interest on these loans, and borrowers had more money for spending in their hands. The medieval goldsmiths were the first to practice fractional reserve banking. Modern fractional reserve banking is a system in which banks keep only a percentage of their deposits on reserve as vault cash and deposits at the Fed. In a 100 percent reserve banking system, banks would be unable to create money by making loans. However, as you will learn momentarily, holding less than 100 percent on reserve allows banks to make loans, and in turn, these loans create money in the economy. 19–1a Banker Bookkeeping We begin our exploration of how the fractional reserve banking system operates in the United States by looking at the balance sheet of a single bank, Typical Bank. A balance sheet is a statement of the assets and liabilities of a bank at a given point in time. Balance sheets are called T-accounts . The hypothetical T-account of Typical Bank in Balance Sheet 1 lists only major categories and omits details to keep things simple. On the right side of the balance sheet are the bank’s liabilities . Liabilities are the amounts the bank owes to others. In our example, the only liabilities are checkable deposits , or demand deposits. Note that checkable deposits are assets on the customers’ personal Fractional reserve banking A system in which banks keep only a percentage of their deposits on reserve as vault cash and deposits at the Fed.
eBook - ePub- Lynne Hamill, Nigel Gilbert(Authors)
- 2015(Publication Date)
- Wiley(Publisher)
9 Banking9.1 Introduction
Banks are part of almost everyone’s lives in the United Kingdom: people use banks for everyday transactions, to hold their savings and to lend them money as indicated by the stylised facts in Box 9.1 . Banking is based on a powerful mechanism, fractional reserve banking, which is the focus of this chapter.Box 9.1 Stylised facts about borrowing, savings and banking by households in Great Britain.
Almost all households have a bank account.- Only 2% of adults ‘lived in households without access to a current or basic bank account, or savings account’ in 2008/2009 (HM Treasury, 2010).
- A third of households had no savings at all.
- 40% had savings of less than £10 000.
- About 20 had savings of £20 000 or more.
- A quarter of households had a mortgage on their main residence, on average £92 000 (ONS, 2011, p.18).
- Half of households had non-property related debt: on average £7000 (ONS, 2012, pp.13–15).
Fractional reserve banking
Fractional reserve banking allows banks to make money or, rather, create credit. Banks do this by ‘exploiting the fact that money left on deposit could profitably be lent out to borrowers’ (Ferguson, 2008, p.49). This is not new. It can be traced back to the founding of the Swedish Riksbank in 1656 and was described by Adam Smith in the eighteenth century (1776/1861, Book II, Chapter II).Fractional reserve banking works like this. The bank needs to hold a percentage of the sum deposited with it to meet day-to-day demand for cash withdrawals. This percentage is called the reserve ratio. If the reserve ratio is 10%, then the bank can lend out 90% of its deposits. So if a bank takes in £1000, then it is free to lend out £900. This means that there is now £1900. The recipient of the loan uses that £900 to buy something. The money is then passed to a retailer, who puts it in the bank. The bank then has another £900 deposited and can lend out a further £810 (being 90% of £900). The total money in circulation is now £2710 (being £1000 plus £900 plus £810). A fourth round adds a further £729, bringing the total to £3439. And so it continues, with less being lent out at each round. After about 50 rounds, there is less than £5 to lend out. But by then, the original £1000 has grown to almost £10 000. The bank deposit multiplier, which records the ratio of the total loaned out to the initial loan, is 10. This is illustrated in the figures in the top row of Box 9.2 , with the mathematics in the bottom row. To sum up, as a result of fractional reserve banking with a reserve ratio of 10%, an initial £1 000 can be increased to £10 000 (assuming that there is a demand for these loans). (For more on this, see, e.g. Begg et al
eBook - PDFIntroduction to Finance
Markets, Investments, and Financial Management
- Ronald W. Melicher, Edgar A. Norton(Authors)
- 2020(Publication Date)
- Wiley(Publisher)
The Treasury carries out its debt management policy by operating in a “regular and predictable” manner to mini- mize disruption in the financial markets and to support fiscal and monetary policies. LO 5.6 The U.S. banking system is a Fractional Reserve System where depository institutions must hold funds at their regional Reserve Banks equal to a certain percentage of their deposit liabilities. Since an individual depository institution is required to hold only a portion of its deposits as reserves, the remaining funds from a new deposit can be lent to borrowers who, in turn, may deposit the funds they receive in the same or another bank in the banking system, and so forth. An estimate of the potential change in check- able deposits, a component of the M1 money supply, can be made by dividing the amount of an increase (or decrease) in excess reserves by the required reserves ratio. LO 5.7 The factors or transactions that affect bank reserves include changes in the demand for currency by the nonbank public; Fed trans- actions, such as changes in the required reserves ratio, open-market operations, and changes in bank borrowings; and U.S. Trea- sury actions involving changes in Treasury spending from its accounts held at Reserve Banks and changes in its cash holdings. LO 5.8 The monetary base consists of banking system reserves plus currency held by the public, while the money multiplier is the number of times the monetary base can be expanded to produce a money supply level. Multiplying the monetary base times the money multi- plier produces the amount of the M1 money supply. The velocity of money is the average number of times each dollar is spent on pur- chases of goods and services. By dividing nominal gross domestic product by M1 pro- duces a measure of the velocity of money.
eBook - PDF- Irvin B. Tucker, Irvin Tucker(Authors)
- 2016(Publication Date)
- Cengage Learning EMEA(Publisher)
How-ever, as you will learn momentarily, holding less than 100 percent on reserve allows banks to make loans, and in turn, these loans create money in the economy. 15-1a BANKER BOOKKEEPING We begin our exploration of how the fractional reserve banking system operates in the United States by looking at the balance sheet of a single bank, Typical Bank. A balance sheet is a statement of the assets and liabilities of a bank at a given point in time. Balance sheets are called T-accounts . The hypothetical T-account of Typical Bank in Balance Sheet 1 lists only major categories and omits details to keep things simple. On the right side of the balance sheet are the bank ’ s liabilities . Liabilities are the amounts the bank owes to others. In our example, the only liabilities are checkable depos-its , or demand deposits. Note that checkable deposits are assets on the customers ’ per-sonal balance sheets, but they are debt obligations of Typical Bank. If a depositor writes a check against his or her checking account, the bank must pay this amount. Therefore, checkable deposits are liabilities to the bank. On the left side of the balance sheet, we see Typical Bank ’ s assets . Assets are amounts the bank owns. In our example, these assets consist of required reserves , excess reserves , and loans . Required reserves are the minimum balance of reserves that the Fed Fractional reserve banking A system in which banks keep only a percentage of their deposits on reserve as vault cash and deposits at the Fed. Required reserves The minimum balance that the Fed requires a bank to hold in vault cash or on deposit with the Fed. 398 PART 5 | Money, Banking, and Monetary Policy Copyright 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
eBook - PDF- Tucker, Irvin Tucker(Authors)
- 2016(Publication Date)
- Cengage Learning EMEA(Publisher)
How-ever, as you will learn momentarily, holding less than 100 percent on reserve allows banks to make loans, and in turn, these loans create money in the economy. 25-1a BANKER BOOKKEEPING We begin our exploration of how the fractional reserve banking system operates in the United States by looking at the balance sheet of a single bank, Typical Bank. A balance sheet is a statement of the assets and liabilities of a bank at a given point in time. Balance sheets are called T-accounts . The hypothetical T-account of Typical Bank in Balance Sheet 1 lists only major categories and omits details to keep things simple. On the right side of the balance sheet are the bank ’ s liabilities . Liabilities are the amounts the bank owes to others. In our example, the only liabilities are checkable depos-its , or demand deposits. Note that checkable deposits are assets on the customers ’ per-sonal balance sheets, but they are debt obligations of Typical Bank. If a depositor writes a check against his or her checking account, the bank must pay this amount. Therefore, checkable deposits are liabilities to the bank. On the left side of the balance sheet, we see Typical Bank ’ s assets . Assets are amounts the bank owns. In our example, these assets consist of required reserves , excess reserves , and loans . Required reserves are the minimum balance of reserves that the Fed Fractional reserve banking A system in which banks keep only a percentage of their deposits on reserve as vault cash and deposits at the Fed. Required reserves The minimum balance that the Fed requires a bank to hold in vault cash or on deposit with the Fed. 670 PART 7 | Money, Banking, and Monetary Policy Copyright 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
eBook - ePubMoney, Banking, and the Business Cycle
Volume II: Remedies and Alternative Theories
- B. Simpson(Author)
- 2014(Publication Date)
- Palgrave Macmillan(Publisher)
If America had a completely free market in its banking and monetary system, that is, if it had a banking and monetary system with no government deposit insurance; no government “lender of last resort”; no government examinations, assurances or inspections; no government imposed capital requirements, restrictions on competition or extended liability for bank shareholders; and no government provided fiat money and Federal Reserve, its banking system would be as sound and as stable as possible. The system would be based on a 100-percent reserve gold standard. This is the monetary and banking system of a free market. Such a system would create a rock-solid foundation on top of which economic progress could take place. Such a system would virtually eliminate the vicious cycle of boom and bust that has come to be known as the business cycle. In succeeding chapters I show just how a 100-percent reserve monetary and banking system would be achieved within the context of a free market in money and banking and how this system would create such a stable financial environment. At this point, I turn to why a free market would not lead to fractional reserves.WHY A FREE MARKET WOULD NOT LEAD TO FRACTIONAL RESERVESAs I stated at the start of the previous section, it is often believed that if banks were free to lend reserves on checking deposits, they would hold very little reserves backing such deposits. In fact, many who do not understand the nature of banking, and business in general, believe that banks would hold no reserves if they were legally allowed to do so. Regardless of the level of reserves it is claimed banks would hold, most people believe that banks would certainly hold significantly less than 100-percent reserves. As I have stated, it is my contention that this is not true. My claim is that a free market in money and banking tends to lead banks to hold 100-percent reserves on their checking deposits (and banknotes issued). I discuss in the next chapter just how it will lead to 100-percent reserves. In this section I focus on two points: why banks have the right to issue fiduciary media and why if this right is protected it will not lead to banks holding fractional reserves.Why Banks Have the Right to Issue Fiduciary MediaThe issuance of fiduciary media, by itself, does not violate individual rights.18 It can be performed in a way that is consistent with the protection and respect for rights. Some economists, such as Hans-Hermann Hoppe, Jörg Guido Hülsmann, and Walter Block, believe that the issuance of fiduciary media is in every case an act of fraud and thus a violation of individual rights. They state, “any contractual agreement that involves presenting two different individuals as simultaneous owners of the same thing (or alternatively, the same thing as simultaneously owned by more than one person) is objectively false and thus fraudulent.”19
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