What is a Fractional Banking System?

Published by Thomas Herold in Banking, Economics, Laws & Regulations

'Fractional Banking System' is explained in detail and with examples in the Laws & Regulations edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.

The fractional banking system is also known as the fractional reserve banking system. This system is the way that virtually all modern day banks around the world operate. In a fractional reserve banking system, banks actually only maintain a small amount of their deposited funds in reserve forms of cash and other easily liquid assets.

The rest of the deposits they loan out, even though all of their deposits are allowed to be withdrawn at the customers’ demand. Fractional banking happens any time that banks loan out money that they bring in from deposits.

Fractional banking systems are ones where banks constantly expand the money supply beyond the levels at which they exist. Because of this, total money supplies are commonly a multiple bigger than simply the currency created by the nation’s central bank. The multiple is also known as the money multiplier. Its amount is determined by a reserve requirement that the financial overseers set.

This fractional reserve system is managed ultimately by central banks and these reserve requirements that they enforce. On the one hand, it sets a limit on the quantity of money that is created by the commercial banks. The other purpose of it is to make certain that banks keep enough readily available cash in order to keep up with typical withdrawal demands of customers. Even though this is the case, there can be problems. Should many depositors at once attempt to take out their money, then a run on the bank might occur. If this happens on a large national or regional scale, the possibility of a banking systemic crisis emerges.

Central banks attempt to reduce these problems. They keep a close eye on commercial banks through regulations and oversight. Besides that, they promise to help out banks that fall into difficulties by acting as their ultimate lender of last resort. Finally, central banks instill confidence in the fractional reserve banking system by guaranteeing the deposits of the customers of the commercial banks.

A significant amount of criticism has been leveled against this fractional reserve banking system. Mainstream critics have complained that because money is only created as individuals borrow from the banking system, the system itself forces people to take on debt in order for money to actually be created. They say that this debases the currency. The biggest problem that they have with the commercial banking system growing the money supply is that it is literally creating money from nothing.

Other critics associate fractional banking with fiat currencies, or money that is only valuable because the governments say that they are. They decry these as negative aspects of current money systems. They dislike that fractional banking systems and fiat money together do not place any limits on how much a money supply can ultimately grow. This can lead to bubbles in both capital markets and assets, such as real estate, stock markets, and commodities. All of these can be victims of speculation, which is made easier by the creation of money through debt in the fractional reserve system.

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The term 'Fractional Banking System' is included in the Laws & Regulations edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.