The basic practice of fractional reserve banking is for a bank to keep a minimum cash balance at all times. That may sound odd at first blush. However, banks do not keep all deposits solvent. Instead, cash is used as capital for other projects and loans, which earn interest and stimulate the economy.

Fractional reserve banking is an American banking policy. It is a measure required by the United States Board of Governors and the Federal Reserve System.

Reserve banking means two things: 

  • First, American banks do not keep on hand all of the cash deposits of its users. 
  • And second, the central bank of the United States sets the minimum limit for a bank’s reserve. The cash is kept by the federal reserve, and not by the bank.

The rationale behind the reserve is preventative. It is designed to guard against bank runs. A bank run is when too many people want to make large withdrawals and the bank is overdrawn due to a lack of cash reserve. This happened during the Great Depression when people were panicking from the financial disaster. 

So, fractional reserve banking is a policy that responds to several economic waves of panic. A bank run happens when people get scared because the economy is tanking, and then they withdrawal all of their cash from the bank. This is never good because that is not the way an interconnected modern economy works. 

But there are numerous economic events when people have tried to make bank runs throughout history. The short of it is, a bank run is a panic move brought on by the fear, or reality, of bankruptcy and financial disaster.

The policy was enacted in 1913, when the Federal Reserve System was formed. Due to other economic problems, the Federal Reserve was designed to regulate banking and while tyring to avoid economic collapse.

Keeping Banks Liquid

In light of these serious financial missteps, a reserve fund ensures that a bank is solvent in the event of significant withdrawals. So, in an effort to avoid banks becoming overdrawn, or worse, bankrupting large institutions, the central bank mandates a certain minimal liquidity, or the fractional reserve required.

Furthermore, fractional reserve banking is meant to prevent banks from generating too much money by making too many loans. This can become a problem if the bank does not have a substantial enough money (cash) base. In the event of significant withdrawals, and the bank does not have enough cash, it risks becoming insolvent and contributing to yet another financial crisis. 

Dollars and Cents

You may know that banks do not keep all of their deposits in cash. Instead, they use the cash for loans and capital for investments. By doing so they’re able to earn interest, freeing up cash to use in investing.  

This is now a common practice that started by the Bank of Amsterdam. During the 17th century, the Bank of Amsterdam realized that people would exchange the bank notes that represented gold as if they were the actual gold. So, the gold didn’t need to exchange hands for it to change ownership. Banknotes, or what is now cash, represented gold or silver bullion at one point in history.

Because banks were exchanging gold, the gold remained at the actual bank. And the savvy investors that these capitalists were, the Bank of Amsterdam realized there was more money to be made by charging for loans, and that cash could be freed up to use for other investments.

Theoretically what this means is that with lower fractional reserves, banks are able to put more into the economy as a whole. While on the other hand, an increase in fractional reserve minimums takes money from the economy. This is because there is less being invested in new projects. It also means that with lower reserves, banks can leverage themselves up the wazoo. 

IOR

How does this all work? By remaining solvent, the bank earns IOR, which is the interest rate on service. The IOR is what all American banks, even those without reserves, are paid to keep up their minimum reserve. However, banks with fewer assets are not required to hold reserves.

Here is the basic breakdown of requisite reserve funds: 

  • If the bank has less than $16 million, they have no minimum reserve requirement
  • Then, between $16 million and $122.3 million, banks are required to maintain a liquidity ratio of 3% of NTAs (net tangible assets).
  • Finally, those which exceed $122.3 million, must have a liquidity ratio of 10% of NTAs

Multiplier Equation

So we have two basic reasons for fractional reserve banking; the first is so that there is enough liquidity in a bank to match withdrawals. And the second is to free up capital so that banks can produce new capital.

The Multiplier Equation is thus an equation that analysts use to estimate the impact of a reserve on the economy. The equation provides an approximation of the amount of money that is potentially created with the fractional reserve system. It is calculated by multiplying the initial deposit by one divided by the reserve requirement. 

The formula looks like this:

M = 1/R

Countries Without Fractional Reserve Banking

Fractional Reserve Banking is primarily an American banking policy, which was primarily a response to the Great Depression. Countries such as Canada, the UK and Australia do not require banks to hold a reserve fund. 

Instead, these countries are required to hold a certain amount of capital; which is called a capital requirement. Similar to the fractional reserve fund, it is a requirement used to ensure that large institutions do not overreach their financial limitations and risk becoming insolvent. 

A capital requirement is based on a ratio of equity to debt. And is a combination of liabilities and equity. It is quite different from a reserve requirement as the reserve requirement is in cash. The key difference is that capital requirements are a source of funds and not a use of funds. 

Criticisms

There can be a certain economic benefit to keeping the fractional reserve fund low. Essentially, fractional reserve banking is a measure that was put in place due to the fiscal irresponsibility of large banks and governments.

There are economists who criticize the practice. They argue that it leads to irresponsible overspending; take for example the mortgage collapse of 2008 and the Great Depression. 

Another criticism of the practice is that it leads to inequality. This is how Austrian economists, Jesús Huerta de Soto and Murray Rothbarda, interpret the practice. These economists see it as a legalized form of embezzlement, using other people’s money to make more money, only for a few. Thus, there is the added concern that it is only benefiting large financial institutions and the small portion of individuals who can benefit from such concentrated wealth.

Highlights

  • Fractional reserve banking is a measure that was installed by the American Federal Reserve. It is also referred to as a “liquid ratio,” and is held by the Federal Reserve.
  • It is an American regulation that ensures that banks have sufficient liquidity in the event of a “bank run.”
  • Reserves are held in chequing accounts, but not on savings or investment funds.
  • The American dollar no longer uses the gold standard. So, reserve funds are fiat currency.
  • Reserve banking is seen as a necessity because banks do not keep all deposits in cash. Instead, collective funds are used as capital for other investment projects.
  • Banks are only required to keep a fraction of deposits solvent. The majority of deposits are used for new investments and to earn interest.
  • Those countries without fractional reserve measures often have other policies to ensure capital adequacy
trade predictions