What is Fractional Reserve Banking? - Definition & History

Instructor: Benjamin Broughton
Fractional reserve banking sounds pretty complicated, but it is a business banking model that is surprisingly easy to understand. It is a process by which a bank takes in, and lends out money while still maintaining sufficient funds in reserve available for depositors. As part of this system, central banks manage the way banks operate and limit how much of their funds can be loaned. In this lesson we will find out how this process works.

Fractional Reserve Banking in Action

The year is 1849, a year after the California gold rush began. You are a gold miner. Until now, you have scraped by on what little gold dust you can find. Security has not been a problem for you because you only hold a few ounces of gold at a time. Today after finding pounds of the yellow treasure in a new river bed, you need a place more secure to store your earnings other than your pants pocket.

What do you do now? Storing your earnings at a local bank is a good idea. The banker (we'll call him Banker Joe) is a smart fellow himself. He realizes that he can only charge so much for gold storage and would like to make more. One day a local business owner comes to him and says, 'Banker Joe, I sure wish I had the money to expand my store and add a restaurant. There is always a line out the door at the restaurant down the street.'

It is in a moment like this that fractional reserve banking was born. You see Banker Joe now realizes he can lend out a 'fraction,' of the deposits from gold miners and charge interest for outstanding loans while providing money to businesses to help them expand.

Banker Joe Gets Greedy

This fraction of deposits in reserve as a percentage shrinks as Banker Joe continues to lend out ever more loans to local businesses. One day a miner having made her fortune comes in and asks for the money she has on deposit from Banker Joe. This particular miner has been very lucky, and her deposits consist of more of the gold or cash than Banker Joe has kept in reserve for withdrawal. When others in the community learn of this, they become concerned about their money or gold in his bank.

This causes a run on the bank, forcing Joe to close his bank as every miner in town demands the gold he or she has on deposit. Bank runs are bad for everyone. Now all the banks in town have no money to lend to new businesses because there is a general uneasiness amongst the mining community about putting money into banks. Miners also lose out because they are now hoarding their gold in their camps which increases their risk of being robbed. Without a safe place to put their gold, they don't stray far from their camps thereby impacting local businesses and the overall amount of gold produced.

Central Banks to the Rescue

As you can see from this small example, the lack of trust in the community leads to less money for everyone. The central banks of countries (known as the Federal Reserve in the U.S.) were founded to solve problems just like these. They are responsible for managing the regulations of currency and banking. These central banks have been established in almost every country in the world. They set limits on how much a bank can lend out as a percentage of the deposits they have on hand or, 'fraction of reserves.' These percentages have changed over time for a variety of reasons.

The most recent increase in the reserve requirement, (the amount of deposits required to be placed in reserve not to be lent out.) was instituted by the U.S. Federal Reserve to reduce the risk that banks would fail like Banker Joe's bank. In 2007, it was discovered that banks had overextended themselves by using too high a ratio of their deposits. This led to banks collapsing all over the world. The increase of bank reserve requirements decreases the risk of bank failure in the banking system.

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