How To Guide For: A Look At Fractional Reserve Banking --- The Advantages & Disadvantages

Fractional Reserve Banking is a banking system in which only a fraction of the total deposits managed by a bank must be kept in reserve. The amount of the deposits equals the amount of the reserves times the deposit multiplier. In the U.S., this system is maintained by the Federal Reserve Board. 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 receive loans from banks, or open interest-generating accounts. The way fractional reserve banking works is that the bank essentially borrows from its depositors to offer loans to people who apply for them. Banks may also choose to invest deposited funds in various ways. If you bank in an institution which uses the fractional reserve system, this means that you are indirectly funding the loans and investments made by the bank. Now lets take a look at the advantages and disadvantages of fractional reserve banking. An advantage of fractional reserve banking is every time your bank borrows from you to make a loan to another bank customer, it gets to charge interest on the loan and pocket the interest. If you have money in an account which generates interest, you get a cut of the interest charged on loans, but the bank still pockets a significant portion of it. Another advantage is that fractional reserve banking is a great way to control inflation, by mandating the money available to make loans. Fewer loans will reduce the supply of money available and increase interest rates by commercial banks. Now let's take a look at a disadvantage. One disadvantage is when there is an excess of the amount of money people demand as withdrawals in a day, and the bank cannot come up with the money, the bank falls below its reserve requirement and faces a liquidity squeeze. Liquidity problems can be compounded when a bank makes poor lending decisions, and borrowers default on loans. When a customer defaults, the bank loses the borrowed money, along with the income from interest. Too many bad loans can cripple a bank, causing it to become insolvent. There is so much more to learn about fractional reserve banking. To learn more about fractional reserve banking, click on the pictures below to read the articles.