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Fractional Reserve Banking: Definition, Benefits and Drawbacks with Examples
28 October 2022
Fractional Reserve Banking is a banking system where banks are obliged to hold a certain portion of your deposits as a reserve. It comprises a part of the total deposit made by a customer available in liquid form. So, whenever you go to the bank to withdraw cash from the deposited amount, the bank uses this reserve amount for withdrawal.
Now the question is what happens to the total deposited amount of yours? Let’s dive in to better understand fractional reserve banking in India.
What is Fractional Reserve Banking?
Fractional Reserve Banking refers to the system where a bank holds a certain portion of your deposited money in reserve form and loans out the remaining amount to another party. The reserve amount is available for the depositor to withdraw.
Is the reserve amount regulated? Yes, the RBI (Reserve Bank of India) decides the proportion of funds banks must keep in reserve.
History of Fractional Reserve Banking System
The fractional reserve system was introduced in the United Kingdom in the 16th century. It started out as a system where banks kept only a fraction of gold deposited on a one-to-one basis. The rest could be loaned out.
The reserve system continued when paper money replaced gold, but the reserve ratio decreased. This was because paper money was much more liquid than gold. Therefore, the banks needed fewer funds in reserve.
Today, the fractional reserve system is a common practice across the majority of the countries across the world.
Under the fractional reserve banking system, the central bank declares a minimum ratio of deposits to the total deposits with a bank that all the banks must maintain. This allows banks to earn interest income, infuse money into the economy, and multiply wealth.
Due to a bank’s ability to grow and multiply a single deposit it received into a bigger sum using the lending and borrowing process, banks are also termed as ‘money multipliers’.
Let’s take a look at an example to understand how the system works.
Say you have Rs. 50,000 in your savings account. Your bank keeps 10% of that in reserve and pools the rest (Rs. 45,000) to lend to borrowers.
If those people deposit Rs. 50,000 with their banks, those banks also keep 10% of that in reserve. However, if 50 people have Rs. 50,000 deposited in their accounts, the entire Rs. 2,50,000 is being held as reserves by the banks.
This means that, in the event that a few depositors want to withdraw all of their deposited money, the bank can give them their required amount. This system is in place assuming that not all the depositors of a bank will come together to withdraw their entire deposits at the same time.
How are Fractional Reserves Used?
As mentioned above, the reserve is the amount of money that banks keep in their vaults. Let us assume that the reserve ratio is 10%.
When you deposit Rs. 10,000 in your bank account, the bank will only keep Rs. 1,000 in reserve. It will then lend out the other Rs. 9,000 and collect interest on it.
Meanwhile, the depositors are earning interest on the amount that they have deposited. The net earning of a bank is the difference between the interest it has earned from loans and the interest it has to pay to its depositors.
The RBI currently requires banks to maintain a cash reserve ratio of 4.5% and a statutory liquidity ratio of 18% of the amount of all deposits that they have received.
Example of Fractional Reserve Banking
The following is an example of fractional reserve banking:
Assume that you deposit Rs. 10.000 in a bank. You will earn interest on that amount, and the bank will hold it for you in exchange for managing your account, giving you access to your money, and other services.
The bank will use your Rs. 10,000 to lend to others who need money. They will charge interest on the loan, and that money will go into the bank’s general fund. That fund will eventually be used to pay the interest on your deposit.
What are the Benefits of Fractional Reserve Banking
Here are some advantages fractional reserve banking has in the banking ecosystem:
1. Helps Banks make Money
This system requires banks to keep a certain percentage of their deposits with them as reserves, allowing them to use the rest. This way, banks can leverage their assets to make more loans and investments, earning interest. The bank’s earnings are the difference between the interest earned and interest paid.
2. Helps in case of a Financial Crisis
The reserve ratio is regulated by the central bank. When the central bank feels that the economic outlook is unfavourable, it may increase the reserve ratio and ask banks to keep more deposits with them. If a large number of depositors would need to withdraw their funds, the bank will be able to provide it.
3. Helps Stimulate Growth in the Economy
Banks can multiply money in the economy by continuing to lend a percentage of deposits it earns. This has a multiplier effect and boosts the cash in the economy.
4. Helps the RBI Control Money Supply
In case of inflationary pressures, the money supply must be contracted. In such a situation, the RBI increases the reserve ratio. The opposite happens when there are deflationary pressures.
What are the Limitations of Fractional Reserve Banking
However, there are certain drawbacks of fractional reserve banking.
1. Increases the Risk of Bank Failure
In case a large number of depositors come to withdraw their funds, but the funds have been lent out by the bank, they will have to find other ways to pay the depositor. This depletes their resources. Increased severity of this situation leads to bank failures.
2. Can have Inflationary Effects
As banks lend more, the money supply increases in the economy, leading to increased levels of inflation.
Things to Know about Fractional Reserve Banking
Banks are required to hold a certain amount of funds in reserve. It’s called the reserve ratio, and it’s determined by the central bank. The higher the reserve ratio, the more funds that banks need to keep on hand.
Banks use some of their deposits to make loans to people who need money. Banks can also make investments with the money they borrow.
Fractional reserve banking is a common system in place throughout the world. Under this, banks are allowed to lend out the money they receive as deposits after keeping a certain percentage of it as reserves. This allows banks to earn more, stimulate economic growth, and allow more people to fulfil their financial needs.
Q1. What is fractional reserve banking?
Ans. Fractional reserve banking is a banking system that requires banks to hold only a fraction of their deposits in reserve. The leftover amount can be lent out by them.
Q2. Can banks lend out more than their deposits?
Ans. Yes. Banks can lend out any amount more than the basic minimum amount required to be kept as reserves at any point.
Q3. Who decides the reserve ratio in India?
Ans. The Reserve Bank of India declares the reserve ratios from time to time, and these must be adhered to by every bank in the country.
Q4. What are the pros of the fractional reserve banking system?
Ans. The pros of fractional reserve banking are that it allows banks to earn more, it helps in a financial crisis, it stimulates economic growth, and it allows RBI to control inflationary pressures.
Q5. What are the cons of the fractional reserve banking system?
Ans. The cons of this system are that it increases the chances of bank failure and it may lead to inflationary pressures in the economy.
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information, and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
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