Fractional reserve banking is a system in which banks are only required to hold a fraction of their customers’ deposits in reserve and can use the rest for lending and other investments. This system allows banks to create money through the process of lending, as they can lend out more money than they actually have in reserves. However, it also raises legal, moral, and economic concerns.
Legal and Moral Issues:
The fact that customers are not informed that banks will not hold 100 percent of their deposits raises legal and moral issues over the nature of fractional-reserve banking. While banks are mandated to produce customers’ money in full upon request, the fractional-reserve system ensures that this can’t be possible for all customers at once .
Economic Concerns:
Critics have likened fractional-reserve banking to a “house of cards,” expressing worries that there’s nothing to back the assets in the system and that the economy may eventually collapse. Many also fear that market participants will lose confidence in the system .
Alternatives to Fractional-Reserve Banking
Full-Reserve Banking:
An alternative to the fractional-reserve system is a full-reserve banking system in which banks would keep 100% of all deposits on hand at all times. This could apply to all deposits or only those intended for immediate cash needs, such as checking and savings accounts. However, if banks are required to hold more in reserve, then less cash will be available for hand to meet various needs .
Central Bank Digital Currency (CBDC):
The Federal Reserve is exploring the possibility of a Central Bank Digital Currency, the implementation of which might profoundly impact the fractional-reserve banking system as we know it .
Historical Context and Impact
Fractional reserve banking has been instrumental in historical events such as the Great Depression, where a number of banks failed, leading to people losing their life savings. This event was instrumental in the establishment of the US government-funded Federal Deposit Insurance Corporation (FDIC) in 1933, which protects customer funds up to $250,000 per depositor per insured bank, should that bank fail. Anything more than this limit is lost, however .
In the 21st century, some banks had taken fractional reserve banking to a whole new level, funding most of their loans not from cash deposits from savers, but with loans from other banks, often secured against bundles of previous loans. This led to significant challenges during the global financial meltdown after 2008 .
Fractional reserve banking has been a subject of exploration and discussion in the context of monetary policy and the stability of the banking system , .