Fractional reserve banking is a financial system wherein banks are legally allowed to hold only a fraction of the total amount deposited by customers. The fraction, known as the reserve ratio, is determined by the central banks and typically ranges from 1-20% of the total deposits. The remaining portion of the deposits is lent out by the banks to borrowers, creating credit and expanding the money supply.
Under this system, banks essentially create money by extending loans that exceed the amount of money they actually hold in reserve. When individuals or businesses borrow from the bank, the newly created money is then deposited into other banks and the process repeats itself, resulting in a multiplier effect on the money supply. This enables banks to play a crucial role in the economy by facilitating economic activity through lending and investment.
Fractional reserve banking, despite its benefits, also poses risks. The primary risk is that in times of economic downturn or financial crisis, depositors may rush to withdraw their money, causing a bank run. If multiple depositors simultaneously demand withdrawals, the bank may not have enough reserves to satisfy all the requests, leading to potential insolvency and a collapse of public confidence in the banking system.
To mitigate these risks, central banks employ various regulatory measures, such as setting reserve requirements and conducting regular monitoring and stress tests on banks. These measures aim to maintain stability, confidence, and liquidity within the banking system while also ensuring that banks can meet their obligations to depositors.
