Fractional reserve banking allows banks to generate funds by only keeping a portion of their deposits on hand. This system allows for loans and interest-bearing accounts, but can lead to liquidity problems and insolvency if too many bad loans are made. Many countries support fractional reserve banking and have agencies to regulate and insure deposits.
Fractional reserve banking is a form of banking where banks are required to keep only a portion of their total deposits on hand. Most banks around the world use this system, because fractional reserve banking is what allows banks to generate funds. It’s also what allows people to get loans from banks or open interest-bearing accounts. The alternative to fractional-reserve banking is full-reserve banking, where a bank must be able to keep all of its deposits on hand.
Some form of fractional-reserve banking has been practiced in the banking industry for a long time. The way fractional reserve banking works is that the bank essentially borrows from its depositors to offer loans to people who ask for them. Banks can also choose to invest deposited funds in a variety of ways. If you bank with an institution that uses the fractional reserve system, this means that you are indirectly funding the loans and investments made by the bank; so if you bank at the same institution that handles your mortgage, you could say you lent yourself some of the money!
The advantage of fractional reserve banking is that it allows banks to generate income on deposited funds. Every time your bank borrows from you to make a loan to another bank customer, they charge interest on the loan, pocketing the interest. If you have money in an interest-bearing account, you get a reduction in the interest charged on your loans, but the bank still pockets a significant portion of it. Fractional reserve banking is a big investment in a very literal way, which is why many banks like this system.
The downside of fractional reserve banking is that it puts banks in an awkward position when it comes to liquidity. While banks aren’t required to keep their deposits on hand, they do need to be able to redeem deposits on demand, such as when a customer comes in to close a checking account. If a group of depositors ask their bank for money at once, in a situation known as a bankruptcy, the bank may not have enough funds on hand, which could be a major problem.
Liquidity problems can be exacerbated when a bank makes poor lending decisions and borrowers default on loans. When a customer defaults, the bank loses the borrowed money, along with interest income, and has to scramble to make up the shortfall. Too many bad loans can cripple a bank, causing it to become insolvent.
Many nations support fractional-reserve banking, with agencies such as the Federal Reserve Bank in the United States acting to regulate and supervise fractional-reserve banking. To address depositor concerns, some countries have government agencies that insure deposits up to a certain amount, and those agencies may also carry out regular checks on returning banks to ensure they are not caught by surprise when a bank becomes insolvent.
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