Fractional Reserve Banking

Fractional reserve banking defines the general banking methods of offering higher credit in comparison to the bank’s holding of reserves while the money provided is utilized and then put into the same banking institution or a separate one. With the help of this procedure, the banking institutions according to the contemporary economy usually offer loans to their clients manifold to the total amount of credit reserve in their holding. Virtually, if there is increase in the money supply in terms of dollars being converted then there can be inflation in the economy. This has been witnessed by applying the concept of the quantity theory of money.

In reality, it happens in some instances that a bank has issued a loan and the equal amount of money came back to the same banking institution and as a result, the bank gets more funds for the purpose of lending. The deposit creation multiplier explains the procedure how the commercial banking institutions exercise fractional reserve banking.

Reserves (gold reserves, silver reserves, and the United States Bonds in the earlier banking period and the United States Credit or Bonds in the contemporary banking period) are a particular type of money that may be kept by the commercial banking institutions by putting it in the central bank or in their own bank vaults.
These reserves are commonly defined as high-powered money types and are required for carrying out fractional reserve banking. If a bank holds bank reserves that implies the bank has the capacity to loan more currency to the clients in comparison to what it holds as deposit.

The principal financial ratio applied for analyzing fractional reserve banking is the cash reserve ratio. The cash reserve ratio is defined as the ratio between reserves and notes and demand deposits.

The regulatory measures for fractional reserve banking are the following:

Minimum capital ratios
Minimum required reserve ratios or RRRs
100% Marginal Reserve prerequisites for issuance of notes, for example the Peels Act 1844 (United Kingdom)
Government bond deposit necessities for issuance of notes
The approval on bank defaults and safeguards against creditors for a number of months or years
Central bank backing for banks in trouble, as well as government guarantee funds for deposits and notes, both for counterbalancing bank withdrawals and for protecting creditors of the bank

According to some economists and the quantity theory of money, fractional reserve banking causes inflation, however, it is debatable.

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Last Updated on : 1st July 2013

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