Fractional-reserve banking
Fractional-reserve banking is the most common form of banking practised by commercial banks worldwide. It involves banks accepting deposits from customers and making loans to borrowers, while holding in reserve an amount equal to only a fraction of the bank's deposit liabilities. Bank reserves are held as cash in the bank or as balances in the bank's account at the central bank. The minimum amount that banks are required to hold in liquid assets is determined by the country's central bank, and is called the reserve requirement or reserve ratio. Banks usually hold more than this minimum amount, keeping excess reserves.
Bank deposits are usually of a relatively short-term duration while loans made by banks tend to be longer-term – this requires banks to hold reserves to provide liquidity when deposits are withdrawn. Banks, working on the expectation that only a proportion of depositors will seek to withdraw funds at the same time, keep only a fraction of their liabilities as reserves. Thus, they can experience an unexpected bank run, when depositors wish to withdraw more funds than the reserves held by the bank. In that event, the bank experiencing the liquidity shortfall may borrow from other banks in the interbank lending market; or if there is a general lack of liquidity among the banks, the country's central bank may act as lender of last resort to provide banks with funds to cover this short-term shortfall.
Because banks hold reserves in amounts that are less than the amounts of their deposit liabilities, and because the deposit liabilities are considered money in their own right, fractional-reserve banking permits the money supply to grow beyond the amount of the underlying base money originally created by the central bank. In most countries, the central bank regulates bank credit creation, imposing reserve requirements and capital adequacy ratios. This helps ensure that banks are solvent and have enough funds to meet demand for withdrawals, and can be used to limit the process of money creation in the banking system. However, rather than directly controlling the money supply, central banks usually pursue an interest rate target to control bank issuance of credit and the rate of inflation.
History
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. 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 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.
These early financial crises led to the creation of central 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 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, to 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.
Regulatory framework
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. 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, 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 provide credit, 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 or riskier classes of financial assets 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 transformation function of fractional-reserve banking is a role that many economists consider to be an important function of the commercial banking system.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.
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.
Money creation process
When a loan is made by the commercial bank, the bank is keeping only a fraction of central bank money as reserves and the money supply expands by the size of the loan. This process is called "deposit multiplication".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.
The money creation process is also affected by the currency drain ratio, and the safety reserve ratio. Data for "excess" reserves and vault cash are published regularly by the Federal Reserve in the United States.
Types of money
There are two types of money created in a fractional-reserve banking system operating with a central bank:- 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.
- Commercial bank money: demand deposits in the commercial banking system; also referred to as "chequebook money", "sight deposits" or simply "credit".
The exact mechanism behind the creation of commercial bank money has been a controversial issue. In 2014, a study titled "Can banks individually create money out of nothing? — The theories and the empirical evidence" empirically tested the manner in which this type of money is created by monitoring a cooperating bank's internal records. The study finds that:
This study establishes for the first time empirically that banks individually create money out of nothing. The money supply is created as ‘fairy dust’ produced by the banks individually, "out of thin air".
Money multiplier
The money multiplier is a heuristic used to demonstrate the maximum amount of broad money that could be created by commercial banks for a given fixed amount of base money and reserve ratio. This theoretical maximum is never reached, because some eligible reserves are held as cash outside of banks. Rather than holding the quantity of base money fixed, central banks have recently pursued an interest rate target to control bank issuance of credit indirectly so the ceiling implied by the money multiplier does not impose a limit on money creation in practice.Formula
The money multiplier, m, is the inverse of the reserve requirement, R:Money supplies around the world
In countries where fractional-reserve banking is prevalent, commercial bank money usually forms the majority of the money supply. The acceptance and value of commercial bank money is based on the fact that it can be exchanged freely at a commercial bank for central bank money.The actual increase in the money supply through this process may be lower, as 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
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:- Minimum required reserve ratios
- Minimum capital ratios
- Government bond deposit requirements for note issue
- 100% Marginal Reserve requirements for note issue, such as the Bank Charter Act 1844
- Sanction on bank defaults and protection from creditors for many months or even years, and
- 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
- generating too much money by making too many loans against the narrow money deposit base;
- having a shortage of cash when large deposits are withdrawn.
In others, the central bank does not require reserves to be held at any time - that is, it does not impose reserve requirements.
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
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:- Selling or redeeming other assets, or securitization of illiquid assets,
- Restricting investment in new loans,
- Borrowing funds,
- Issuing additional capital instruments, or
- Reducing dividends.
- Demand deposits with other banks
- High quality marketable debt securities
- Committed lines of credit with other banks
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. 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.
Hypothetical example of a bank balance sheet and financial ratios
An example of fractional-reserve banking, and the calculation of the "reserve ratio" is shown in the balance sheet below:In this example the cash reserves held by the bank is NZ$3,010m and the Demand Deposits of the bank are NZ$25,482m, for a cash reserve ratio of 11.81%.
Other financial ratios
The key financial ratio used to analyze fractional-reserve banks is the cash reserve ratio, which is the ratio of cash reserves to demand deposits. However, other important financial ratios are also used to analyze the bank's liquidity, financial strength, profitability etc.For example, the ANZ National Bank Limited balance sheet above gives the following financial ratios:
- The cash reserve ratio is $3,010m/$25,482m, i.e. 11.81%.
- The liquid assets reserve ratio is /$25,482m, i.e. 18.86%.
- The equity capital ratio is $8,703m/107,787m, i.e. 8.07%.
- The tangible equity ratio is /107,787m, i.e. 5.02%
- The total capital ratio is /$107,787m, i.e. 9.99%.
Criticisms of textbook descriptions of the monetary system
, governor of the Reserve Bank of Australia, said of the "money multiplier", "most practitioners find it to be a pretty unsatisfactory description of how the monetary and credit system actually works."Lord Turner, formerly the UK's chief financial regulator, said "Banks do not, as too many textbooks still suggest, take deposits of existing money from savers and lend it out to borrowers: they create credit and money ex nihilo – extending a loan to the borrower and simultaneously crediting the borrower’s money account".
Former Deputy Governor of the Bank of Canada William White said "Some decades ago, the academic literature would have emphasised the importance of the reserves supplied by the central bank to the banking system, and the implications for the growth of money and credit. Today, it is more broadly understood that no industrial country conducts policy in this way under normal circumstances."
Criticisms
Criticisms on the basis of instability
In 1935, economist Irving Fisher proposed a system of 100% reserve banking as a means of reversing the deflation of the Great Depression. He wrote: "100 per cent banking... would give the Federal Reserve absolute control over the money supply. Recall that under the present fractional-reserve system of depository institutions, the money supply is determined in the short run by such non-policy variables as the currency/deposit ratio of the public and the excess reserve ratio of depository institutions."Today, monetary reformers argue that fractional reserve banking leads to unpayable debt, growing inequality, inevitable bankruptcies, and an imperative for perpetual and unsustainable economic growth.