How does fractional reserve banking work?


How does fractional reserve banking work?

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Fractional reserve banking is pretty simple. Under this system, let’s say a bank has a million dollars in deposits from its accountholders. The bank is not required to maintain a million dollars in reserve to satisfy this; instead, they only need to maintain some fraction of it, and they’re free to lend the remainder to borrowers.

Banking is a mix of two things: deposit and loans. There are of course a lot of financial “instruments” nowadays, but most of them boil down to these two categories.

Deposit is simple: you hand your money to bank but you can still spend it. And the end of the year, if you still have some money left in your account, the bank gives you some additional money so you keep your money at that bank. Deposit works with current money and (for interests) past money. It’s safe until the whole bank fails (there are additional protection mechanisms like FDIC or equivalent, but let’s not lose track).

A loan is a way to exchange current money for *future* money. Banks give you current money in exchange for future money. Since no one knows if you’ll pay back, and individuals can default more easily than banks, this is a somewhat risky business, so the bank takes some steps like checking your current situation and asking for some interest you have to pay back along with the original sum.

Modern retail banks handle both deposits and loans.

A deposit-only bank would only profit from transaction fees and similar.

A loan-only bank doesn’t really work unless people take loans “in turns” or the bank starts with a lot of money. Let’s say a loan-only bank starts with a 100k USD capital. The first customer asks for a 100k loan. He’s a very reliable guy and will almost certainly repay the loan… but now the bank has now money and has to wait some time before getting back something. Now, a bank wouldn’t lend its entire capital to one guy, but you get my point.

Combining deposits and loans banks can have a more reasonable business model. Basically, the bank can use some money from the deposit accounts and lend them to people. This means they can lend to more people (remember the previous example). More people can potentially buy homes (as long as they’re considered safe customers and there are enough houses) and so on.

The catch is, of course, that customers can always come back and ask for their money. So you cannot just take all their money and lend them to someone else. First, because the borrower may never pay back and also because, in the mean time, the deposit customer would have no money.

So there is a tradeoff between bank profit (and general “movement” of money in the economy as a whole), on one side, and deposit safety on the other. This tradeoff results in:

1) limits on how much the bank can take from deposit accounts and lend them to other customers,

2) some kind of authority checking that banks really respect those (and other) limits and stepping in, if necessary, when a bank fails.

This is the fractional reserve banking model. It is called fractional because a fraction of the deposits can be lent.

The “multiplier” you often hear about when discussing fractional reserve banking is due to the combination of this fraction and interest rates on loans.

Let’s say a bank starts with 100k from a single customer. Let’s say they can lend 10% of that to someone else. The borrower will get that money with a 2% interest loan. In the end, assuming everything goes well, the bank will have 90k (money they cannot touch) + 10k (original loan sum) + 200 dollars from loan interests. Of course these are rookie numbers, but as you get more and more customers the result can be more significant.

10 people each deposit $100 in the bank. So the bank has $1,000 worth of deposits.

The bank lends some of this $1,000 out to people. But they always keep $200 in their vault as reserves, so that if any of their depositors come and want to withdraw their money, they can have it. It’s fine that they don’t have all $1,000 in the vault all the time, because it’s unlikely that all 10 people will want to withdraw all of their money at once.

So the banks keep a *fraction* in *reserve*. Fractional-reserve banking.