Fractional-reserve banking

Fractional-reserve banking is the practice whereby a bank accepts deposits, and holds reserves that are a fraction of the amount of its deposit liabilities. Reserves are held at the bank as currency, or as deposits in the bank's accounts at the central bank. Fractional-reserve banking is the current form of banking practiced in most countries worldwide.

Fractional-reserve banking allows banks to act as financial intermediaries between borrowers and savers, and to provide longer-term loans to borrowers while providing immediate liquidity to depositors (providing the function of maturity transformation). However, a bank can experience a bank run if depositors wish to withdraw more funds than the reserves held by the bank. To mitigate the risks of bank runs and systemic crises (when problems are extreme and widespread), governments of most countries regulate and oversee commercial banks, provide deposit insurance and act as lender of last resort to commercial banks.

Because bank deposits are usually considered money in their own right, and because banks hold reserves that are less than their deposit liabilities, fractional-reserve banking permits the money supply to grow beyond the amount of the underlying reserves of base money originally created by the central bank. In most countries, the central bank (or other monetary authority) regulates bank credit creation, imposing reserve requirements and capital adequacy ratios. This can limit the amount of money creation that occurs in the commercial banking system, and helps to ensure that banks are solvent and have enough funds to meet demand for withdrawals. However, rather than directly controlling the money supply, central banks usually pursue an interest rate target to control inflation and bank issuance of credit.

History

See also: Banknote

Fractional-reserve banking predates the existence of governmental monetary authorities and originated many centuries ago in bankers' realization that generally not all depositors demand payment at the same time.

In the past, savers looking to keep their coins and valuables in safekeeping depositories deposited gold and silver at goldsmiths, receiving in exchange a note for their deposit(see Bank of Amsterdam). These notes gained acceptance as a medium of exchange for commercial transactions and thus became an early form of circulating paper money.As the notes were used directly in trade, the goldsmiths observed that people would not usually redeem all their notes at the same time, and they saw the opportunity to invest their coin reserves in interest-bearing loans and bills. This generated income for the goldsmiths but left them with more notes on issue than reserves with which to pay them. A process was started that altered the role of the goldsmiths from passive guardians of bullion, charging fees for safe storage, to interest-paying and interest-earning banks. Thus fractional-reserve banking was born.

If creditors (note holders of gold originally deposited) lost faith in the ability of a bank to pay their notes, however, many would try to redeem their notes at the same time. If, in response, a bank could not raise enough funds by calling in loans or selling bills, the bank would either go into insolvency or default on its notes. Such a situation is called a bank run and caused the demise of many early banks.

The Swedish Riksbank was the world's first central bank, created in 1668. Many nations followed suit in the late 1600s to establish central banks which were given the legal power to set the reserve requirement, and to specify the form in which such assets (called the monetary base) are required to be held. In order to mitigate the impact of bank failures and financial crises, central banks were also granted the authority to centralize banks' storage of precious metal reserves, thereby facilitating transfer of gold in the event of bank runs, to regulate commercial banks, impose reserve requirements, and to act as lender-of-last-resort if any bank faced a bank run. The emergence of central banks reduced the risk of bank runs which is inherent in fractional-reserve banking, and it allowed the practice to continue as it does today

During the twentieth century, the role of the central bank grew to include influencing or managing various macroeconomic policy variables, including measures of inflation, unemployment, and the international balance of payments. In the course of enacting such policy, central banks have from time to time attempted to manage interest rates, reserve requirements, and various measures of the money supply and monetary base.

How it works

In most legal systems, a bank deposit is not a bailment. In other words, the funds deposited are no longer the property of the customer. The funds become the property of the bank, and the customer in turn receives an asset called a deposit account (a checking or savings account). That deposit account is a liability on the balance sheet of the bank. Each bank is legally authorized to issue credit up to a specified multiple of its reserves, so reserves available to satisfy payment of deposit liabilities are less than the total amount which the bank is obligated to pay in satisfaction of demand deposits.

Fractional-reserve banking ordinarily functions smoothly. Relatively few depositors demand payment at any given time, and banks maintain a buffer of reserves to cover depositors' cash withdrawals and other demands for funds. However, during a bank run or a generalized financial crisis, demands for withdrawal can exceed the bank's funding buffer, and the bank will be forced to raise additional reserves to avoid defaulting on its obligations. A bank can raise funds from additional borrowings (e.g., by borrowing in theinterbank lending market or from the central bank), by selling assets, or by calling in short-term loans. If creditors are afraid that the bank is running out of reserves or is insolvent, they have an incentive to redeem their deposits as soon as possible before other depositors access the remaining reserves. Thus the fear of a bank run can actually precipitate the crisis.

Many of the practices of contemporary bank regulation and central banking, including centralized clearing of payments, central bank lending to member banks, regulatory auditing, and government-administered deposit insurance, are designed to prevent the occurrence of such bank runs.

Economic function

Fractional-reserve banking allows banks to create credit in the form of bank deposits, which represent immediate liquidity to depositors. The banks also provide longer-term loans to borrowers, and act as financial intermediaries for those funds. Less liquid forms of deposit (such as time deposits) or riskier classes of financial assets (such as equities or long-term bonds) may lock up a depositor's wealth for a period of time, making it unavailable for use on demand. This "borrowing short, lending long," or maturity transformationfunction of fractional-reserve banking is a role that many economists consider to be an important function of the commercial banking system.

Additionally, according to macroeconomic theory, a well-regulated fractional-reserve bank system also benefits the economy by providing regulators with powerful tools for influencing the money supply and interest rates. Many economists believe that these should be adjusted by the government to promote macroeconomic stability.

The process of fractional-reserve banking expands the money supply of the economy but also increases the risk that a bank cannot meet its depositor withdrawals. Modern central banking allows banks to practice fractional-reserve banking with inter-bank business transactions with a reduced risk of bankruptcy.

Money creation process

Main article: Money creation

There are two types of money in a fractional-reserve banking system operating with a central bank:

1. Central bank money: money created or adopted by the central bank regardless of its form – precious metals, commodity certificates, banknotes, coins, electronic money loaned to commercial banks, or anything else the central bank chooses as its form of money.
2. Commercial bank money: demand deposits in the commercial banking system; sometimes referred to as "chequebook money"

When a deposit of central bank money is made at a commercial bank, the central bank money is removed from circulation and added to the commercial banks' reserves (it is no longer counted as part of M1 money supply). Simultaneously, an equal amount of new commercial bank money is created in the form of bank deposits. When a loan is made by the commercial bank (which keeps only a fraction of the central bank money as reserves), using the central bank money from the commercial bank's reserves, the M1 money supply expands by the size of the loan. This process is called "deposit multiplication".

Creation of deposit liabilities through the lending process

The proceeds of most bank loans are not in the form of currency. Banks typically make loans by accepting promissory notes in exchange for credits they make to the borrowers' deposit accounts. Deposits created in this way are sometimes called derivative deposits and are part of the process of creation of money by commercial banks. Issuing loan proceeds in the form of paper currency and current coins is considered to be a weakness in internal control.

Example of deposit multiplication

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The table below displays the mathematical model of the effect of the creation of loans and corresponding demand deposits, and how the money supply is affected by that process. It also shows how central bank money is used to create commercial bank money from an initial deposit of $100 of central bank money. In the example, the initial deposit is, conceptually, lent out 10 times (although as noted above, the banks do not fund most loans with the currency the banks have received as deposits) with a fractional-reserve rate of 20% to ultimately create $500 of commercial bank money (it is important to note that the 20% reserve rate used here is for ease of illustration, actual reserve requirements are usually much lower, for example around 3% in the USA and UK). Each successive bank involved in this process creates new commercial bank money on a diminishing portion of the original deposit of central bank money. This is because banks only lend out a portion of the central bank money deposited, in order to fulfill reserve requirements and to ensure that they always have enough reserves on hand to meet normal transaction demands.

The relending model begins when an initial $100 deposit of central bank money is made into Bank A. Bank A takes 20 percent of it, or $20, and sets it aside as reserves, and then can theoretically loan out the remaining 80 percent, or $80. If the bank does in fact issue loan proceeds in the form of $80 in central bank money, the money supply actually totals $180, not $100, because the bank has loaned out $80 of the central bank money, kept $20 of central bank money in reserve (not part of the money supply), and substituted a newly created $100 IOU claim for the depositor that acts equivalently to and can be implicitly redeemed for central bank money (the depositor can transfer it to another account, write a check on it, demand his cash back, etc.). These claims by depositors on banks are termed demand deposits or commercial bank money and are simply recorded in a bank's accounts as a liability (specifically, an IOU to the depositor). From a depositor's perspective, commercial bank money is equivalent to central bank money – it is impossible to tell the two forms of money apart unless a bank run occurs.^[3]

At this point in the relending model, Bank A now only has $20 of central bank money on its books. The loan recipient is holding $80 in central bank money, but he soon spends the $80. The receiver of that $80 then deposits it into Bank B. Bank B is now in the same situation as Bank A started with, except it has a deposit of $80 of central bank money instead of $100. Similar to Bank A, Bank B sets aside 20 percent of that $80, or $16, as reserves and lends out the remaining $64, increasing money supply by $64. As the process continues, more commercial bank money is created. To simplify the table, a different bank is used for each deposit. In the real world, the money a bank lends may end up in the same bank so that it then has more money to lend out.

Although no new money was physically created in addition to the initial $100 deposit, new commercial bank money is created through loans. The boxes marked in red show the location of the original $100 deposit throughout the entire process. The total reserves will always equal the original amount, which in this case is $100. As this process continues, more commercial bank money is created. The amounts in each step decrease towards a limit. If a graph is made showing the accumulation of deposits, one can see that the graph is curved and approaches a limit. This limit is the maximum amount of money that can be created with a given reserve rate. When the reserve rate is 20%, as in the example above, the maximum amount of total deposits that can be created is $500 and the maximum increase in the money supply is $400.

For an individual bank, the deposit is considered a liability whereas the loan it gives out and the reserves are considered assets. This is the basis for a bank's balance sheet. Fractional-reserve banking allows the money supply to expand or contract. Generally the expansion or contraction of the money supply is dictated by the balance between the rate of new loans being created and the rate of existing loans being repaid or defaulted on. The balance between these two rates can be influenced to some degree by actions of the central bank. However, the central bank has no direct control over the amount of money created by commercial (or high street) banks.

Money multiplier

Main article: Money multiplier

The expansion of $100 through fractional-reserve banking with varying reserve requirements. Each curve approaches a limit. This limit is the value that the "money multiplier'" calculates.

A mechanism used to calculate the maximum size of the money supply from any given quantity of base money and a given reserve ratio, is known as the "money multiplier". Rather than directly limiting the money supply however, central banks typically pursue an interest rate target to control bank issuance of credit. The central bank simply supplies whatever amount of base money is demanded by the economy at the prevailing level of interest rates.

Formula

The money multiplier, m, is the inverse of the reserve requirement, R:

Example

For example, with the reserve ratio of 20 percent, this reserve ratio, R, can also be expressed as a fraction:

So then the money multiplier, m, will be calculated as:

This number is multiplied by the initial deposit to show the maximum amount of money it can be expanded to.

The money creation process is also affected by the currency drain ratio (the propensity of the public to hold banknotes rather than deposit them with a commercial bank), and the safety reserve ratio (excess reserves beyond the legal requirement that commercial banks voluntarily hold – usually a small amount). Data for "excess" reserves and vault cash are published regularly by the Federal Reserve in the United States. In practice, the actual money multiplier varies over time, and may be substantially lower than the theoretical maximum

Money supplies around the world

Components of US money supply (currency, M1, M2, and M3) since 1959. In January 2007, the amount of "central bank money" was $750.5 billion while the amount of "commercial bank money" (in the M2 supply) was $6.33 trillion. M1 is currency plus demand deposits; M2 is M1 plus time deposits, savings deposits, and some money-market funds; and M3 is M2 plus large time deposits and other forms of money. The M3 data ends in 2006 because 

Components of the euro money supply 1998–2007

See also: Money supply

Fractional-reserve banking determines the relationship between the amount of "central bank money" in the official money supply statistics and the total money supply. Most of the money in these systems is "commercial bank money".. The issue of money through the banking system is a mechanism of monetary transmission, which a central bank can influence only indirectly by raising or lowering interest rates(although banking regulations may also be adjusted to influence the money supply, depending on the circumstances).

This table gives an outline of the makeup of money supplies worldwide. Most of the money in any given money supply consists of commercial bank money. The value of commercial bank money is based on the fact that it can be exchanged freely at a bank for central bank money.

The actual increase in the money supply through this process may be lower, as (at each step) banks may choose to hold reserves in excess of the statutory minimum, borrowers may let some funds sit idle, and some members of the public may choose to hold cash, and there also may be delays or frictions in the lending process. Government regulations may also be used to limit the money creation process by preventing banks from giving out loans even though the reserve requirements have been fulfilled.

Regulation

Because the nature of fractional-reserve banking involves the possibility of bank runs, central banks have been created throughout the world to address these problems.

Central banks

Main article: Central bank

Government controls and bank regulations related to fractional-reserve banking have generally been used to impose restrictive requirements on note issue and deposit taking on the one hand, and to provide relief from bankruptcy and creditor claims, and/or protect creditors with government funds, when banks defaulted on the other hand. Such measures have included:

1. Minimum required reserve ratios (RRRs)
2. Minimum capital ratios
3. Government bond deposit requirements for note issue
4. 100% Marginal Reserve requirements for note issue, such as the Bank Charter Act 1844 (UK)
5. Sanction on bank defaults and protection from creditors for many months or even years, and
6. Central bank support for distressed banks, and government guarantee funds for notes and deposits, both to counteract bank runs and to protect bank creditors.

Reserve requirements

The currently prevailing view of reserve requirements is that they are intended to prevent banks from:

1. generating too much money by making too many loans against the narrow money deposit base;
2. having a shortage of cash when large deposits are withdrawn (although the reserve is thought to be a legal minimum, it is understood that in a crisis or bank run, reserves may be made available on a temporary basis).

In some jurisdictions, (such as the United States and the European Union), the central bank does not require reserves to be held during the day. Reserve requirements are intended to ensure that the banks have sufficient supplies of highly liquid assets, so that the system operates in an orderly fashion and maintains public confidence.

In addition to reserve requirements, there are other required financial ratios that affect the amount of loans that a bank can fund. The capital requirement ratio is perhaps the most important of these other required ratios. When there are no mandatory reserve requirements, which are considered by some economists to restrict lending, the capital requirement ratio acts to prevent an infinite amount of bank lending.

Liquidity and capital management for a bank

Main articles: Capital requirement and Market liquidity

To avoid defaulting on its obligations, the bank must maintain a minimal reserve ratio that it fixes in accordance with, notably, regulations and its liabilities. In practice this means that the bank sets a reserve ratio target and responds when the actual ratio falls below the target. Such response can be, for instance:

1. Selling or redeeming other assets, or securitization of illiquid assets,
2. Restricting investment in new loans,
3. Borrowing funds (whether repayable on demand or at a fixed maturity),
4. Issuing additional capital instrument, or
5. Reducing dividends.

Because different funding options have different costs, and differ in reliability, banks maintain a stock of low cost and reliable sources of liquidity such as:

1. Demand deposits with other banks
2. High quality marketable debt securities
3. Committed lines of credit with other banks

As with reserves, other sources of liquidity are managed with targets.

The ability of the bank to borrow money reliably and economically is crucial, which is why confidence in the bank's creditworthiness is important to its liquidity. This means that the bank needs to maintain adequate capitalisation and to effectively control its exposures to risk in order to continue its operations. If creditors doubt the bank's assets are worth more than its liabilities, all demand creditors have an incentive to demand payment immediately, causing a bank run to occur.

Contemporary bank management methods for liquidity are based on maturity analysis of all the bank's assets and liabilities (off balance sheet exposures may also be included). Assets and liabilities are put into residual contractual maturity buckets such as 'on demand', 'less than 1 month', '2–3 months' etc. These residual contractual maturities may be adjusted to account for expected counter party behaviour such as early loan repayments due to borrowers refinancing and expected renewals of term deposits to give forecast cash flows. This analysis highlights any large future net outflows of cash and enables the bank to respond before they occur. Scenario analysis may also be conducted, depicting scenarios including stress scenarios such as a bank-specific crisis.