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Fractional reserve system allows banks to hold a portion of their money supply for loans and withdrawals, but it is not risk-free. A bank collapse may be caused by institutions invested in this system. Most countries use this system, but Islamic countries have slightly different banking systems. The potential for a complete banking collapse is always possible due to risks such as a bank run, but many central banks provide insurance on deposits made and are willing to lend to banks to avoid a complete collapse.
A fractional reserve system is a banking system in which commercial banks hold only a portion of the money they hold in a central bank. This modern banking system is used across most of the world in one way or another. While this system is the most popular commercial banking arrangement, it is not risk-free. A major risk of engaging in fractional reserve banking is that a collapse may be caused by a bank being invested by institutions that participate in this form of banking.
Commonly referred to simply as an FRS, a fractional reserve system allows banks to hold onto a portion of their money supply for the purpose of making loans and supporting customer withdrawals. In this system, only a portion of a bank’s total cash supply is held in a central bank in the country where the commercial bank is located. A central bank determines the minimum reserve amount and this is established in a monetary policy which all banks in a particular country must adhere to.
Historically, banks have used other systems, such as backing deposits with gold. Most countries around the world today, however, operate using some variation of a fractional reserve system. Due to religious beliefs against earning and collecting interest on lent money, banks operating in Islamic countries engage in slightly different business than commercial banks located in other non-Islamic countries. In most cases, however, some variant of the system is still used in Islamic countries.
While the fractional reserve system is widely used throughout much of the world, it is still not a perfect system as the potential for a complete banking collapse is always possible. A major risk factor related to this system involves a run to the bank, where customers who fear a bank failure may request all account withdrawals at the same time, thus creating a shortage of cash available for withdrawal and, therefore, creating a kind of self-fulfilling prophecy. Such widespread activity can be triggered by financial forecasts predicting the failure of a bank and causing mass panic among bank customers. While risks such as a bank run are inherent in the fractional reserve system, many central banks are prepared for such events and provide insurance on deposits made. Some central banks are even willing to lend to banks when a run occurs to avoid a complete collapse.
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