What is fractional reserve?

Fractional reserve is a banking system that allows commercial banks to earn profits by lending out a portion of their customers' deposits, while only a small fraction of these deposits is actually kept as real money available for withdrawals. Essentially, this banking mechanism creates money out of nothing, using a percentage of customers' bank deposits.

In other words, banks are required to keep a minimum percentage (a fraction) of the money deposited in their financial accounts, meaning they can lend the rest. When a bank issues a loan, both the institution and the borrower consider the funds as assets, thus doubling the initial amount in economic terms. This money is reused, reinvested, and lent repeatedly, leading to a new multiplier effect. This is how the fractional reserve banking system "creates new money".

Loans and debts are an integral part of the fractional reserve banking system and often require a central bank to put new funds into circulation so that commercial banks can meet withdrawals. Most central banks also act as regulators that determine, among other things, the minimum reserve requirements. This banking system is the most commonly used by national financial institutions. Therefore, it is widely used in the United States and in many other free trade-based countries.

The origin of the fractional reserve banking system

The fractional reserve banking system emerged around 1668, when the Swedish Riksbank (Sveriges) became the world's first central bank, although more rudimentary forms of this system were already in use. The idea that money deposits could increase and grow, stimulating the economy through loans, quickly became popular. In fact, it was quite logical to use available resources to encourage spending, rather than storing them in a vault.

After Sweden took steps to make the practice more official, the fractional reserve structure was established and quickly spread. Thus, two central banks were created in the United States, the first in 1791 and the second in 1816, but neither lasted. In 1913, the Federal Reserve Act created the Federal Reserve Bank of the U.S. (FED), which is now the central bank of the United States. The goals of this financial institution are to stabilize, maximize, and supervise the economy in relation to prices, employment, and interest rates.

How does it work?

When a customer deposits money into their bank account, that money is no longer the property of the depositor, at least not directly. The bank is now the owner and, in return, offers its customers a deposit account from which they can withdraw funds. This means, however, that bank customers must be able to access the entirety of their deposit upon request, in accordance with the current banking rules and procedures.

However, when the bank takes possession of the deposited money, it does not maintain the total value in the customer's account. Instead, it keeps a small percentage of the deposit (the fractional reserve). This reserve value usually varies between 3% and 10%, and the rest of the money is used to grant loans to other customers.

Here are some simple examples of how loans have the ability to create money:

1. Customer A deposits $50,000 in Bank 1. Bank 1 loans $45,000 to Customer B.

2. Client B deposits $45,000 in Bank 2. Bank 2 loans $40,500 to Client C.

3. Client C deposits $40,500 at Bank 3. Bank 3 lends $36,450 to client D.

4. Customer D deposits $36,450 in Bank 4. Bank 4 lends $32,805 to customer E.

5. Client E deposits $32,805 in Bank 5. Bank 5 loans $29,525 to client F.

With a fractional reserve requirement of 10%, the initial deposit of $50,000 has grown to $234,280 in total available currency, which is the sum of all customer deposits at their respective institutions. Although this is a very simplified example of how the fractional reserve banking system generates money through the multiplier effect, it illustrates the basic idea in a concrete way.

Please note that the process is based on the principal of the debt ( the value on which the interest of the loan is calculated ). Deposit accounts represent the money that banks owe to their customers ( liabilities ), while interest-generating loans are what produces more money for banks because they are an asset. In summary, banks make money by generating more assets in their loan accounts than in their liabilities of current accounts ( deposits ).

And the banking panic?

What happens if all the fund holders of a particular bank decide to show up and withdraw all their money? This is called a bank run because, as the bank is only required to keep a small fraction of its customers' deposits, it is likely to fail due to its inability to meet its financial obligations.

For the fractional reserve banking system to function, it is essential that depositors do not all go to the banks at the same time to withdraw or access all their funds. Although bank runs have occurred in the past, this is generally not the normal way customers behave. In fact, priori, users attempt to withdraw all their money only if they believe the bank is in serious trouble.

In the United States, the Great Depression is a notorious example of the catastrophe that can be caused by a massive withdrawal. Nowadays, the reserves held by banks are one of the means they use to minimize the chances of such an event occurring again. Some banks maintain reserves above the minimum required for this purpose, to better meet the demands of their customers and ensure access to funds in deposit accounts.

Advantages and Disadvantages of the Fractional Reserve Banking System

Although banks make the most profit from this highly lucrative system, a small part of the system also reaches banking customers, who earn interest on their deposit accounts. Governments are also part of this mechanism and often argue that fractional reserve banking systems promote spending and ensure economic stability and growth.

However, many economists believe that the fractional reserve system is unsustainable and even quite risky, especially considering that the current monetary system implemented by most countries is, in fact, based on credit/debt and not on real money. Our economic system is based on the principle that people trust both banks and fiat money, established as legal tender by governments.

Fractional Reserve Banking and Cryptocurrencies

Unlike the traditional fiat currency system, Bitcoin was created as a decentralized digital currency, giving rise to an alternative economic structure that operates in a completely different way.

Like most cryptocurrencies, Bitcoin is managed by a distributed network of nodes. All data is secured by cryptographic proofs and recorded in a large public and distributed ledger called blockchain. This means there is no need for a central bank and no responsible authority.

Moreover, the issuance of Bitcoin is limited, so no additional units will be generated once the maximum supply of 21 million units is reached. Therefore, the context is completely different and there is no fractional reserve in the world of Bitcoin and cryptocurrencies.