# Fractional reserve banking

﻿
Fractional reserve banking

Fractional-reserve banking is a form of banking where banks maintain reserves (of cash and coin or deposits at the central bank) that are only a fraction of the customer's deposits. Funds deposited into a bank are mostly lent out, and a bank keeps only a fraction (called the reserve ratio) of the quantity of deposits as reserves. Some of the funds lent out are subsequently deposited with another bank, increasing deposits at that second bank and allowing further lending. As most bank deposits are treated as money in their own right, fractional reserve banking increases the money supply, and banks are said to create money. Due to the prevalence of fractional reserve banking, the broad money supply of most countries is a multiple larger than the amount of base money created by the country's central bank. That multiple (called the money multiplier) is determined by the reserve requirement or other financial ratio requirements imposed by financial regulators, and by the excess reserves kept by commercial banks.[1][2]

Central banks generally mandate reserve requirements that require banks to keep a minimum fraction of their demand deposits as cash reserves. This both limits the amount of money creation that occurs in the commercial banking system,[2] and ensures that banks have enough ready cash to meet normal demand for withdrawals. Problems can arise, however, when depositors seek withdrawal of a large proportion of deposits at the same time; this can cause a bank run or, when problems are extreme and widespread, a systemic crisis. To mitigate this risk, the governments of most countries (usually acting through the central bank) regulate and oversee commercial banks, provide deposit insurance and act as lender of last resort to commercial banks.

Fractional-reserve banking is the most common form of banking and is practiced in almost all countries. Although Islamic banking prohibits the making of profit from interest on debt, a form of fractional-reserve banking is still evident in most Islamic countries.

## History

Savers looking to keep their valuables in safekeeping depositories deposited gold coins and silver coins at goldsmiths, receiving in turn a note for their deposit (see Bank of Amsterdam). Once these notes became a trusted medium of exchange an early form of paper money was born, in the form of the goldsmiths' notes.[3]

As the notes were used directly in trade, the goldsmiths observed that people would not usually redeem all their notes at the same time, and they saw the opportunity to invest their coin reserves in interest-bearing loans and bills. This generated income for the goldsmiths but left them with more notes on issue than reserves with which to pay them. A process was started that altered the role of the goldsmiths from passive guardians of bullion, charging fees for safe storage, to interest-paying and interest-earning banks. Thus fractional-reserve banking was born.

However, if creditors (note holders of gold originally deposited) lost faith in the ability of a bank to redeem (pay) their notes, many would try to redeem their notes at the same time. If in response a bank could not raise enough funds by calling in loans or selling bills, it either went into insolvency or defaulted on its notes. Such a situation is called a bank run and caused the demise of many early banks.[3]

Repeated bank failures and financial crises led to the creation of central banks – public institutions that have the authority to regulate commercial banks, impose reserve requirements, and act as lender-of-last-resort if a bank runs low on liquidity. The emergence of central banks mitigated the dangers associated with fractional reserve banking.[2][4]

From about 1991 a consensus had emerged within developed economies about the optimum design of monetary policy methods. In essence central bankers gave up attempts to directly control the amount of money in the economy and instead moved to indirect methods by targeting interest rates. This consensus is criticized by some economists.[5]

### Reason for existence

Fractional reserve banking allows people to invest their money, without losing the ability to use it on demand. Since most people do not need to use all their money all the time, banks lend out that money, to generate profit for themselves. Thus, banks can act as financial intermediaries — facilitating the investment of savers' funds.[2][6] Full reserve banking, on the other hand, does not allow any money in such demand deposits to be invested (since all of the money would be locked up in reserves) and less liquid investments (such as stocks, bonds and time deposits) lock up a lender's money for a time, making it unavailable for the lender to use.

According to mainstream economic theory, regulated fractional-reserve banking also benefits the economy by providing regulators with powerful tools for manipulating the money supply and interest rates, which many see as essential to a healthy economy.[7]

## How it works

The nature of modern banking is such that the cash reserves at the bank available to repay demand deposits need only be a fraction of the demand deposits owed to depositors. In most legal systems, a demand deposit at a bank (e.g., a checking or savings account) is considered a loan to the bank (instead of a bailment) repayable on demand, that the bank can use to finance its investments in loans and interest bearing securities. Banks make a profit based on the difference between the interest they charge on the loans they make, and the interest they pay to their depositors (aggregately called the net interest margin (NIM)). Since a bank lends out most of the money deposited, keeping only a fraction of the total as reserves, it necessarily has less money than the account balances of its depositors.

The main reason customers deposit funds at a bank is to store savings in the form of a demand claim on the bank. Depositors still have a claim to full repayment of their funds on demand even though most of the funds have already been invested by the bank in interest bearing loans and securities.[8] Holders of demand deposits can withdraw all of their deposits at any time. If all the depositors of a bank did so at the same time a bank run would occur, and the bank would likely collapse. Due to the practice of central banking, this is a rare event today, as central banks usually guarantee the deposits at commercial banks, and act as lender of last resort when there is a run on a bank. However, there have been some recent bank runs: the Northern Rock crisis of 2007 in the United Kingdom is an example. The collapse of Washington Mutual bank in September 2008, the largest bank failure in history, was preceded by a "silent run" on the bank, where depositors removed vast sums of money from the bank through electronic transfer.[citation needed] However, in these cases, the banks proved to have been insolvent at the time of the run.[citation needed] Thus, these bank runs merely precipitated failures that were inevitable in any case.

In the absence of crises that trigger bank runs, fractional-reserve banking usually functions smoothly because at any one time relatively few depositors will make cash withdrawals simultaneously compared to the total amount on deposit, and a cash reserve can be maintained as a buffer to deal with the normal cash demands from depositors seeking withdrawals. In addition, in a normal economic environment, cash is steadily being introduced into the economy by the central bank, and new funds are steadily being deposited into the commercial banks.

However, if a bank is experiencing a financial crisis, and net redemption demands are unusually large over a period of time, the bank will run low on cash reserves and will be forced to raise additional funds to avoid running out of reserves and defaulting on its obligations. A bank can raise funds from additional borrowings (e.g., by borrowing from the money market or using lines of credit held with other banks), or by selling assets, or by calling in short-term loans. If creditors are afraid that the bank is running out of cash or is insolvent, they have an incentive to redeem their deposits as soon as possible before other depositors access the remaining cash reserves before they do, triggering a cascading crisis that can result in a full-scale bank run.

## Money creation

Modern central banking allows banks to practice fractional reserve banking with inter-bank business transactions with a reduced risk of bankruptcy. The process of fractional-reserve banking expands the money supply of the economy but also increases the risk that a bank cannot meet its depositor withdrawals.[9][10] Though not a mainstream economic belief, a number of central bankers, monetary economists, and text books, have said that banks create money by 'extending credit', where banks obligate themselves to borrowers, and then later manage whatever liabilities this creates for them, where if the central bank targets interest rates, it must supply base money on demand to meet the banks reserve requirements, after the banks have begun the lending process[11][12][13][14][15][16][17][18] and that rather than deposits leading to loans, causality is reversed, and loans lead to deposits.[19][20][21][22]

There are two types of money in a fractional-reserve banking system operating with a central bank:[23][24][25]

1. Central bank money: money created or adopted by the central bank regardless of its form –- precious metals, commodity certificates, banknotes, coins, electronic money loaned to commercial banks, or anything else the central bank chooses as its form of money
2. Commercial bank money: demand deposits in the commercial banking system; sometimes referred to as chequebook money

When a deposit of central bank money is made at a commercial bank, the central bank money is removed from circulation and added to the commercial banks' reserves (it is no longer counted as part of M1 money supply). Simultaneously, an equal amount of new commercial bank money is created in the form of bank deposits. When a loan is made by the commercial bank (which keeps only a fraction of the central bank money as reserves), using the central bank money from the commercial bank's reserves, the m1 money supply expands by the size of the loan.[2] This process is called deposit multiplication.

### Example of deposit multiplication

The table below displays the mainstream economics relending model of how loans are funded and how the money supply is affected. It also shows how central bank money is used to create commercial bank money from an initial deposit of $100 of central bank money. In the example, the initial deposit is lent out 10 times with a fractional-reserve rate of 20% to ultimately create$500 of commercial bank money. Each successive bank involved in this process creates new commercial bank money on a diminishing portion of the original deposit of central bank money. This is because banks only lend out a portion of the central bank money deposited, in order to fulfill reserve requirements and to ensure that they always have enough reserves on hand to meet normal transaction demands.

The relending model begins when an initial $100 deposit of central bank money is made into Bank A. Bank A takes 20 percent of it, or$20, and sets it aside as reserves, and then loans out the remaining 80 percent, or $80. At this point, the money supply actually totals$180, not $100, because the bank has loaned out$80 of the central bank money, kept $20 of central bank money in reserve (not part of the money supply), and substituted a newly created$100 IOU claim for the depositor that acts equivalently to and can be implicitly redeemed for central bank money (the depositor can transfer it to another account, write a check on it, demand his cash back, etc.). These claims by depositors on banks are termed demand deposits or commercial bank money and are simply recorded in a bank's accounts as a liability (specifically, an IOU to the depositor). From a depositor's perspective, commercial bank money is equivalent to central bank money – it is impossible to tell the two forms of money apart unless a bank run occurs (at which time everyone wants central bank money).[2]

At this point in the relending model, Bank A now only has $20 of central bank money on its books. The loan recipient is holding$80 in central bank money, but he soon spends the $80. The receiver of that$80 then deposits it into Bank B. Bank B is now in the same situation as Bank A started with, except it has a deposit of $80 of central bank money instead of$100. Similar to Bank A, Bank B sets aside 20 percent of that $80, or$16, as reserves and lends out the remaining $64, increasing money supply by$64. As the process continues, more commercial bank money is created. To simplify the table, a different bank is used for each deposit. In the real world, the money a bank lends may end up in the same bank so that it then has more money to lend out.

Table Sources:
Individual Bank Amount Deposited Lent Out Reserves
A 100 80 20
B 80 64 16
C 64 51.20 12.80
D 51.20 40.96 10.24
E 40.96 32.77 8.19
F 32.77 26.21 6.55
G 26.21 20.97 5.24
H 20.97 16.78 4.19
I 16.78 13.42 3.36
J 13.42 10.74 2.68
K 10.74

Total Reserves:

89.26

Total Amount of Deposits: Total Amount Lent Out: Total Reserves + Last Amount Deposited:

457.05 357.05 100
The expansion of $100 of central bank money through fractional-reserve lending with a 20% reserve rate.$400 of commercial bank money is created virtually through loans.

Although no new money was physically created in addition to the initial $100 deposit, new commercial bank money is created through loans. The 2 boxes marked in red show the location of the original$100 deposit throughout the entire process. The total reserves plus the last deposit (or last loan, whichever is last) will always equal the original amount, which in this case is $100. As this process continues, more commercial bank money is created. The amounts in each step decrease towards a limit. If a graph is made showing the accumulation of deposits, one can see that the graph is curved and approaches a limit. This limit is the maximum amount of money that can be created with a given reserve rate. When the reserve rate is 20%, as in the example above, the maximum amount of total deposits that can be created is$500 and the maximum increase in the money supply is $400. For an individual bank, the deposit is considered a liability whereas the loan it gives out and the reserves are considered assets. Deposits will always be equal to loans plus a bank's reserves, since loans and reserves are created from deposits. This is the basis for a bank's balance sheet. Fractional reserve banking allows the money supply to expand or contract. Generally the expansion or contraction of the money supply is dictated by the balance between the rate of new loans being created and the rate of existing loans being repaid or defaulted on. The balance between these two rates can be influenced to some degree by actions of the central bank. This table gives an outline of the makeup of money supplies worldwide. Most of the money in any given money supply consists of commercial bank money.[23] The value of commercial bank money is based on the fact that it can be exchanged freely at a bank for central bank money.[23][24] The actual increase in the money supply through this process may be lower, as (at each step) banks may choose to hold reserves in excess of the statutory minimum, borrowers may let some funds sit idle, and some members of the public may choose to hold cash, and there also may be delays or frictions in the lending process.[26] Government regulations may also be used to limit the money creation process by preventing banks from giving out loans even though the reserve requirements have been fulfilled.[27] ### Money multiplier The expansion of$100 through fractional-reserve banking with varying reserve requirements. Each curve approaches a limit. This limit is the value that the money multiplier calculates.

The most common mechanism used to measure this increase in the money supply is typically called the money multiplier. It calculates the maximum amount of money that an initial deposit can be expanded to with a given reserve ratio.

#### Formula

The money multiplier, m, is the inverse of the reserve requirement, R:[28]

$m=\frac1R$

Example

For example, with the reserve ratio of 20 percent, this reserve ratio, R, can also be expressed as a fraction:

$R=\tfrac15$

So then the money multiplier, m, will be calculated as:

$m=\frac{1}{1/5}=5$

This number is multiplied by the initial deposit to show the maximum amount of money it can be expanded to.

The money creation process is also affected by the currency drain ratio (the propensity of the public to hold banknotes rather than deposit them with a commercial bank), and the safety reserve ratio (excess reserves beyond the legal requirement that commercial banks voluntarily hold—usually a small amount). Data for "excess" reserves and vault cash are published regularly by the Federal Reserve in the United States.[29] In practice, the actual money multiplier varies over time, and may be substantially lower than the theoretical maximum.[30]

Confusingly there are many different "money multipliers", some referring to ratios of rates of change of different money measures and others referring to ratios of absolute values of money measures.

### Reserve requirements

The modern mainstream view of reserve requirements is that they are intended to prevent banks from:

1. generating too much money by making too many loans against the narrow money deposit base;
2. having a shortage of cash when large deposits are withdrawn (although the reserve is thought to be a legal minimum, it is understood that in a crisis or bank run, reserves may be made available on a temporary basis).

In practice, some central banks do not require reserves to be held, and in some countries that do, such as the USA and the EU they are not required to be held during the day when the banks are lending, and banks can borrow from other banks at near the central bank policy rate to ensure they have the necessary amount of required reserves by the close of business. Required reserves are therefore considered by some central bankers, monetary economists and text books to only play a very small role in limiting money creation in these countries. Most commentators agree however, that they help the banks have sufficient supplies of highly liquid assets, so that the system operates in an orderly fashion and maintains public confidence. The UK for example, which does not have required reserves, does have requirements that the banks keep a certain amount of cash, and in Australia while there are no reserve requirements, there are a variety of requirements to ensure the banks have a stabilising ratio of liquid assets, such as deposits held with local banks.

In addition to reserve requirements, there are other required financial ratios that affect the amount of loans that a bank can fund. The capital requirement ratio is perhaps the most important of these other required ratios. When there are no mandatory reserve requirements, which are considered by some mainstream economists to restrict lending, the capital requirement ratio acts to prevent an infinite amount of bank lending.

### Alternative views

Theories of endogenous money date to the 19th century, and were described by Joseph Schumpeter, and later the post-Keynesians.[31] Endogenous money theory states that the supply of money is credit-driven and determined endogenously by the demand for bank loans, rather than exogenously by monetary authorities.

Charles Goodhart worked for many years to encourage a different approach to money supply analysis and said the base money multiplier model was "such an incomplete way of describing the process of the determination of the stock of money that it amounts to misinstruction"[32] Ten years later he said: "Almost all those who have worked in a [central bank] believe that this view is totally mistaken; in particular, it ignores the implications of several of the crucial institutional features of a modern commercial banking system...".[33] Goodhart has characterized the money stock as a dependent endogenous variable.[34] In 1994, Mervyn King said that the causation between money and demand is a contentious issue, because although textbooks assume that money is exogenous, in the United Kingdom money is endogenous, as the Bank of England provides base money on demand and broad money is created by the banking system.[35][36][37]

Seth B. Carpenter and Selva Demiralp concluded the simple textbook base money multiplier is implausible in the United States.[38]

## Money supplies around the world

Components of US money supply (currency, M1, M2, and M3) since 1959. In January 2007, the amount of central bank money was $750.5 billion while the amount of commercial bank money (in the M2 supply) was$6.33 trillion. M1 is currency plus demand deposits; M2 is M1 plus time deposits, savings deposits, and some money-market funds; and M3 is M2 plus large time deposits and other forms of money. The M3 data ends in 2006 because the federal reserve ceased reporting it.[clarification needed]
Components of the euro money supply 1998-2007

Fractional-reserve banking determines the relationship between the amount of central bank money (currency) in the official money supply statistics and the total money supply. Most of the money in these systems is commercial bank money. Fractional reserve banking involves the issuance and creation of commercial bank money, which increases the money supply through the deposit creation multiplier. The issue of money through the banking system is a mechanism of monetary transmission, which a central bank can influence indirectly by raising or lowering interest rates (although banking regulations may also be adjusted to influence the money supply, depending on the circumstances).

## Regulation

Because the nature of fractional-reserve banking involves the possibility of bank runs, central banks have been created throughout the world to address these problems.[4][39]

### Central banks

Government controls and bank regulations related to fractional-reserve banking have generally been used to impose restrictive requirements on note issue and deposit taking on the one hand, and to provide relief from bankruptcy and creditor claims, and/or protect creditors with government funds, when banks defaulted on the other hand. Such measures have included:

1. Minimum required reserve ratios (RRRs)
2. Minimum capital ratios
3. Government bond deposit requirements for note issue
4. 100% Marginal Reserve requirements for note issue, such as the Bank Charter Act 1844 (UK)
5. Sanction on bank defaults and protection from creditors for many months or even years, and
6. Central bank support for distressed banks, and government guarantee funds for notes and deposits, both to counteract bank runs and to protect bank creditors.

### Liquidity and capital management for a bank

To avoid defaulting on its obligations, the bank must maintain a minimal reserve ratio that it fixes in accordance with, notably, regulations and its liabilities. In practice this means that the bank sets a reserve ratio target and responds when the actual ratio falls below the target. Such response can be, for instance:

1. Selling or redeeming other assets, or securitization of illiquid assets,
2. Restricting investment in new loans,
3. Borrowing funds (whether repayable on demand or at a fixed maturity),
4. Issuing additional capital instruments, or
5. Reducing dividends.[citation needed]

Because different funding options have different costs, and differ in reliability, banks maintain a stock of low cost and reliable sources of liquidity such as:

1. Demand deposits with other banks
2. High quality marketable debt securities
3. Committed lines of credit with other banks[citation needed]

As with reserves, other sources of liquidity are managed with targets.

The ability of the bank to borrow money reliably and economically is crucial, which is why confidence in the bank's creditworthiness is important to its liquidity. This means that the bank needs to maintain adequate capitalisation and to effectively control its exposures to risk in order to continue its operations. If creditors doubt the bank's assets are worth more than its liabilities, all demand creditors have an incentive to demand payment immediately, a situation known as a run on the bank.[citation needed]

Contemporary bank management methods for liquidity are based on maturity analysis of all the bank's assets and liabilities (off balance sheet exposures may also be included). Assets and liabilities are put into residual contractual maturity buckets such as 'on demand', 'less than 1 month', '2–3 months' etc. These residual contractual maturities may be adjusted to account for expected counter party behaviour such as early loan repayments due to borrowers refinancing and expected renewals of term deposits to give forecast cash flows. This analysis highlights any large future net outflows of cash and enables the bank to respond before they occur. Scenario analysis may also be conducted, depicting scenarios including stress scenarios such as a bank-specific crisis.[citation needed]

### Risk and prudential regulation

In a fractional-reserve banking system, in the event of a bank run, the demand depositors and note holders would attempt to withdraw more money than the bank has in reserves, causing the bank to suffer a liquidity crisis and, ultimately, to perhaps default. In the event of a default, the bank would need to liquidate assets and the creditors of the bank would suffer a loss if the proceeds were insufficient to pay its liabilities. Since public deposits are payable on demand, liquidation may require selling assets quickly and potentially in large enough quantities to affect the price of those assets. An otherwise solvent bank (whose assets are worth more than its liabilities) may be made insolvent by a bank run. This problem potentially exists for any corporation with debt or liabilities, but is more critical for banks as they rely upon public deposits (which may be redeemable upon demand).

Although an initial analysis of a bank run and default points to the bank's inability to liquidate or sell assets (i.e. because the fraction of assets not held in the form of liquid reserves are held in less liquid investments such as loans), a more full analysis indicates that depositors will cause a bank run only when they have a genuine fear of loss of capital, and that banks with a strong risk adjusted capital ratio should be able to liquidate assets and obtain other sources of finance to avoid default[citation needed]. For this reason, fractional-reserve banks have every reason to maintain their liquidity, even at the cost of selling assets at heavy discounts and obtaining finance at high cost, during a bank run (to avoid a total loss for the contributors of the bank's capital, the shareholders)[citation needed].

Many governments have enforced or established deposit insurance systems in order to protect depositors from the event of bank defaults and to help maintain public confidence in the fractional-reserve system.

Responses to the problem of financial risk described above include:

1. Proponents of prudential regulation, such as minimum capital ratios, minimum reserve ratios, central bank or other regulatory supervision, and compulsory note and deposit insurance, (see Controls on Fractional-Reserve Banking below);
2. Proponents of free banking, who believe that banking should be open to free entry and competition, and that the self-interest of debtors, creditors and shareholders should result in effective risk management; and,
3. Withdrawal restrictions: some bank accounts may place a limit on daily cash withdrawals and may require a notice period for very large withdrawals. Banking laws in some countries may allow restrictions to be placed on withdrawals under certain circumstances, although these restrictions may rarely, if ever, be used;
4. Opponents of fractional reserve banking who insist that notes and demand deposits be 100% reserved.

### Example of a bank balance sheet and financial ratios

An example of fractional reserve banking, and the calculation of the reserve ratio is shown in the balance sheet below:

Example 2: ANZ National Bank Limited Balance Sheet as at 30 September 2007[citation needed]
ASSETS NZ$m LIABILITIES NZ$m
Cash 201 Demand Deposits 25482
Balance with Central Bank 2809 Term Deposits and other borrowings 35231
Other Liquid Assets 1797 Due to Other Financial Institutions 3170
Due from other Financial Institutions 3563 Derivative financial instruments 4924
Trading Securities 1887 Payables and other liabilities 1351
Derivative financial instruments 4771 Provisions 165
Available for sale assets 48 Bonds and Notes 14607
Net loans and advances 87878 Related Party Funding 2775
Shares in controlled entities 206 [subordinated] Loan Capital 2062
Current Tax Assets 112 Total Liabilities 99084
Other assets 1045 Share Capital 5943
Deferred Tax Assets 11 [revaluation] Reserves 83
Premises and Equipment 232 Retained profits 2667
Goodwill and other intangibles 3297 Total Equity 8703
Total Assets 107787 Total Liabilities plus Net Worth 107787

In this example the cash reserves held by the bank is $3010m ($201m currency + $2809m held at central bank) and the demand liabilities of the bank are$25482m, for a cash reserve ratio of 11.81%.

#### Other financial ratios

The key financial ratio used to analyze fractional-reserve banks is the cash reserve ratio, which is the ratio of cash reserves to demand deposits. However, other important financial ratios are also used to analyze the bank's liquidity, financial strength, profitability etc.

For example the ANZ National Bank Limited balance sheet above gives the following financial ratios:

1. The cash reserve ratio is $3010m/$25482m, i.e. 11.81%.
2. The liquid assets reserve ratio is ($201m+$2809m+$1797m)/$25482m, i.e. 18.86%.
3. The equity capital ratio is $8703m/107787m, i.e. 8.07%. 4. The tangible equity ratio is ($8703m-$3297m)/107787m, i.e. 5.02% 5. The total capital ratio is ($8703m+$2062m)/$107787m, i.e. 9.99%.

It is very important how the term 'reserves' is defined for calculating the reserve ratio, as different definitions give different results. Other important financial ratios may require analysis of disclosures in other parts of the bank's financial statements. In particular, for liquidity risk, disclosures are incorporated into a note to the financial statements that provides maturity analysis of the bank's assets and liabilities and an explanation of how the bank manages its liquidity.

#### How the example bank manages its liquidity

The ANZ National Bank Limited explains its methods as:[citation needed]

Liquidity risk is the risk that the Banking Group will encounter difficulties in meeting commitments associated with its financial liabilities, e.g. overnight deposits, current accounts, and maturing deposits; and future commitments e.g. loan draw-downs and guarantees. The Banking Group manages its exposure to liquidity risk by maintaining sufficient liquid funds to meet its commitments based on historical and forecast cash flow requirements.
The following maturity analysis of assets and liabilities has been prepared on the basis of the remaining period to contractual maturity as at the balance date. The majority of longer term loans and advances are housing loans, which are likely to be repaid earlier than their contractual terms. Deposits include substantial customer deposits that are repayable on demand. However, historical experience has shown such balances provide a stable source of long term funding for the Banking Group. When managing liquidity risks, the Banking Group adjusts this contractual profile for expected customer behaviour.
Example 2: ANZ National Bank Limited Maturity Analysis of Assets and Liabilities as at 30 September 2007[citation needed]
Total carrying value Less than 3 months 3–12 months 1–5 years Beyond 5 years No Specified Maturity
Assets
Liquid Assets 4807 4807
Due from other financial institutions 3563 2650 440 187 286
Derivative Financial Instruments 4711 4711
Assets available for sale 48 33 1 13 1
Net loans and advances 87878 9276 9906 24142 44905
Other Assets 4903 970 179 3754
Total Assets 107787 18394 10922 25013 45343 8115
Liabilities
Due to other financial institutions 3170 2356 405 32 377
Deposits and other borrowings 70030 53059 14726 2245
Derivative financial instruments 4932 4932
Other liabilities 1516 1315 96 32 60 13
Bonds and notes 14607 672 4341 9594
Related party funding 2275 2275
Loan capital 2062 100 1653 309
Total liabilities 99084 60177 19668 13556 746 4937
Net liquidity gap 8703 (41783) (8746) 11457 44597 3178
Net liquidity gap - cumulative 8703 (41783) (50529) (39072) 5525 8703

## Criticisms

Critics of fractional reserve banking have argued one or more of the following: that it is unstable, that it exacerbates business cycles, that it causes inflation, or that it leads to environmental degradation.

## References

1. ^ Abel, Andrew; Bernanke, Ben (2005), "14.1", Macroeconomics (5th ed.), Pearson, pp. 522–532
2. ^ a b c d e f Mankiw, N. Gregory (2002), "Chapter 18: Money Supply and Money Demand", Macroeconomics (5th ed.), Worth, pp. 482–489
3. ^ a b United States. Congress. House. Banking and Currency Committee. (1964). Money facts; 169 questions and answers on money- a supplement to A Primer on Money, with index, Subcommittee on Domestic Finance ... 1964.. Washington D.C..
4. ^ a b The Federal Reserve in Plain English - An easy-to-read guide to the structure and functions of the Federal Reserve System. See page 5 of the document for the purposes and functions: http://www.frbsf.org/publications/education/plainenglish/index.html
5. ^ "Monetary Policy Regimes: a fragile consensus, Peter Howells and Iris Biefang-Frisancho Mariscal (2006)" (PDF). University of the West of England, Bristol.
6. ^ Abel, Andrew; Bernanke, Ben (2005). "7". Macroeconomics (5th ed.). Pearson. pp. 266–269.
7. ^ Mankiw, N. Gregory (2002). "9". Macroeconomics (5th ed.). Worth. pp. 238–255.
8. ^ Committee on Finance and Industry 1931 (Macmillan Report) on bankers desire to complicate banking issues."The economic experts have evolved a highly technical vocabulary of their own and in their zeal for precision are distrustful, if not derisive of any attempts to popularize their science."
9. ^ Page 57 of 'The FED today', a publication on an educational site affiliated with the Federal Reserve Bank of Kansas City, designed to educate people on the history and purpose of the United States Federal Reserve system. The FED today Lesson 6
10. ^ "Mervyn King, Finance: A Return from Risk". Bank of England. " Banks are dangerous institutions. They borrow short and lend long. They create liabilities which promise to be liquid and hold few liquid assets themselves. That though is hugely valuable for the rest of the economy. Household savings can be channelled to finance illiquid investment projects while providing access to liquidity for those savers who may need it.... If a large number of depositors want liquidity at the same time, banks are forced into early liquidation of assets – lowering their value ...'"
11. ^ "Prof Richard Werner describes credit creation.". WWW.the-free-lunch.com.
12. ^ "Disyatat, P. 2010 The bank lending channel revisited.". Bank for International Settlements. "Page 2. the concept of the [mainstream economics] money multiplier is flawed and uninformative in terms of analyzing the dynamics of bank lending. Page 7 When a loan is granted, banks in the first instance create a new liability that is issued to the borrower. This can be in the form of deposits or a cheque drawn on the bank, which when redeemed, becomes deposits at another bank. A well functioning interbank market overcomes the asynchronous nature of loan and deposit creation across banks. Thus loans drive deposits rather than the other way around."
13. ^ "Paul Tucker, Money and credit: Banking and the Macroeconomy". Bank of England. " banks....in the short run.....lever up their balance sheets and expand credit at will....Subject only but crucially to confidence in their soundness, banks extend credit by simply increasing the borrowing customer's current account.....This 'money creation' process is constrained by their need to manage the liquidity risk from the withdrawal of deposits and the drawdown of backup lines to which it exposes them."
14. ^ "Glen Stevens, the Australian Economy: Then and now". Reserve Bank of Australia. " money multiplier, as an introduction to the theory of fractional reserve banking. I suppose students have to learn that, and it is easy to teach, but most practitioners find it to be a pretty unsatisfactory description of how the monetary and credit system actually works. In large part, this is because it ignores the role of financial prices in the process."
15. ^ "White, W. Changing views on how best to conduct monetary policy: the last fifty years". Bank for International Settlements. "Some decades ago, the academic literature....emphasised the importance of the reserves supplied by the central bank....., and the implications (via the money multiplier) for the growth of money and credit. Today, it is more broadly understood that no industrial country conducts policy in this way under normal circumstances....there has been a decisive shift towards the use of short-term interest rates as the policy instrument [in industrialised countries]. In this framework, cash reserves supplied to the banking system are whatever they have to be to ensure that the desired policy rate is in fact achieved."
16. ^ "Freedman, C. Reflections on Three Decades at the Bank of Canada". Bank of Canada. "It used to be that most academic research treated money (or sometimes base) as the exogenous policy instrument under the control of the central bank. This was an irritant to those of us working in central banks, because the instrument of policy had always been the short-term interest rate, and because all monetary aggregates (beyond base) have always been and remain endogenous. In recent years, more and more academics, in specifying their models, have treated the short-term interest rate as the policy instrument, thereby increasing the usefulness of their analyses..."
17. ^ http://college.holycross.edu/RePEc/eej/Archive/Volume18/V18N3P305_314.pdf Understanding the Remarkable Survival of Multiplier Models of Money Stock Determination. Eastern Economic Journal, 1992, vol. 18, issue 3, pages 305-314
18. ^
19. ^ "(Holmes, 1969 page 73 at the time Senior Vice President of the Federal Reserve Bank of New York responsible for open market operations) I have not seen, cited in Bank and Credit the Scientific Journal of the National Bank of Poland". " In the real world, banks extend credit, creating deposits in the process, and look for reserves later. The question then becomes one of whether and how the Federal Reserve will accommodate the demand for reserves. In the very short run, the Federal Reserve has little or no choice about accommodating that demand… ...'"
20. ^ "Modern Money Mechanics. Page 37. Money Creation and Reserve Management" (PDF). Federal Reserve Bank of Chicago. " Page 7. Of course, they do not really pay out loans from the money they receive as deposits. If they did this, no additional money would be created. What they do when they make loans is to accept promissory notes in exchange for credits to the borrowers' transaction accounts. Loans (assets) and deposits (liabilities) both rise by \$9,000. Reserves are unchanged by the loan transactions. But the deposit credits constitute new additions to the total deposits of the banking system. Page 37. In the real world, a bank's lending is not normally constrained by the amount of excess reserves it has at any given moment. Rather, loans are made, or not made, depending on the bank's credit policies and its expectations about its ability to obtain the funds necessary to pay its customers' checks and maintain required reserves in a timely fashion ...'"
21. ^ "The Transmission of Monetary Policy in Canada". Bank of Canada. "Required reserves have traditionally been justified by a desire to influence the size of the money multiplier and by prudential concerns. However, central banks’ views about money supply determination have for a long time been that the money stock is demand determined"
22. ^ Elements of Banking Made Simple, Hoyle and Whitehead (Oxford: Heinemann, 1989 edition). From preface "specifically designed to meet the requirements of the Institute of Bankers’ Banking Certificate and Foundation Course". Page 22 "Consider a deposit....£1000 in banknotes....(a) We can lend out £700.... This is the simple view of bank lending. (b) It is....possible for us to have deposits of £3333.33. As we only have deposits....of £1000 we can lend out £2333.33, provided we can find borrowers. This is the more sophisticated view of bank lending.
23. ^ a b c Bank for International Settlements - The Role of Central Bank Money in Payment Systems. See page 9, titled, "The coexistence of central and commercial bank monies: multiple issuers, one currency": http://www.bis.org/publ/cpss55.pdf A quick quotation in reference to the 2 different types of money is listed on page 3. It is the first sentence of the document:
"Contemporary monetary systems are based on the mutually reinforcing roles of central bank money and commercial bank monies."
24. ^ a b European Central Bank - Domestic payments in Euroland: commercial and central bank money: http://www.ecb.int/press/key/date/2000/html/sp001109_2.en.html One quotation from the article referencing the two types of money:
"At the beginning of the 20th almost the totality of retail payments were made in central bank money. Over time, this monopoly came to be shared with commercial banks, when deposits and their transfer via cheques and giros became widely accepted. Banknotes and commercial bank money became fully interchangeable payment media that customers could use according to their needs. While transaction costs in commercial bank money were shrinking, cashless payment instruments became increasingly used, at the expense of banknotes"
25. ^ Macmillan report 1931 account of how fractional banking works http://books.google.ca/books?hl=en&id=EkUTaZofJYEC&dq=British+Parliamentary+reports+on+international+finance&printsec=frontcover&source=web&ots=kHxssmPNow&sig=UyopnsiJSHwk152davCIyQAMVdw&sa=X&oi=book_result&resnum=1&ct=result#PPA34,M1
26. ^ http://books.google.com/books?id=I-49pxHxMh8C&pg=PA303&dq=deposit+reserves&lr=&sig=hMQtESrWP6IBRYiiaZgKwIoDWVk#PPA295,M1 William MacEachern, Macroeconomics: A Contemporary Introduction, p. 295
27. ^ ebook: The Federal Reserve - Purposes and Functions:http://www.federalreserve.gov/pf/pf.htm
see pages 13 and 14 of the pdf version for information on government regulations and supervision over banks
28. ^ http://www.mhhe.com/economics/mcconnell15e/graphics/mcconnell15eco/common/dothemath/moneymultiplier.html
29. ^ http://www.federalreserve.gov/releases/h3/Current/ Federal Reserve Board, "AGGREGATE RESERVES OF DEPOSITORY INSTITUTIONS AND THE MONETARY BASE" (Updated weekly).
30. ^ http://books.google.com/books?id=FdrbugYfKNwC&pg=PA169&lpg=PA169&dq=united+states+money+multiplier&source=web&ots=C_Hw1u82xe&sig=m7g0bMz167DijFsOCbn5f4aWAOU#PPA170,M1 Bruce Champ & Scott Freeman, Modeling Monetary Economies, p. 170 (Figure 9.1).
31. ^ A handbook of alternative monetary economics, by Philip Arestis, Malcolm C. Sawyer, p. 53
32. ^ "Goodhart C A E (1984( Monetary Policy in Theory and Practice p.188. I have not seen, cited in Monetary Policy Regimes: a fragile consensus. Peter Howells and Iris Biefang-Frisancho Mariscal" (PDF). University of the West of England, Bristol. " The base-multiplier model of money supply determination (which lies behind the exogenously determined money stock of the LM curve) was condemned years ago as 'such an incomplete way of describing the process of the determination of the stock of money that it amounts to misinstruction ...'(Goodhart 1984. Page 188)"
33. ^
34. ^
35. ^
36. ^ "Paul Tucker, Managing the central bank's balance sheet: Where monetary policy meets financial stability". Bank of England. " given this way of implementing monetary policy, money – both narrow and broad – is largely endogenous. The central bank simply supplies whatever amount of base money is demanded by the economy at the prevailing level of interest rates."
37. ^ "Razzak, W. Money in the Era of Inflation Targeting". Reserve Bank of New Zealand. "In New Zealand....money supply is endogenous"
38. ^ http://www.federalreserve.gov/pubs/feds/2010/201041/index.html Money, Reserves, and the Transmission of Monetary Policy: Does the Money Multiplier Exist? Conclusions
39. ^ Reserve Bank of India - Report on Currency and Finance 2004-05 (See page 71 of the full report or just download the section Functional Evolution of Central Banking): http://www.rbi.org.in/scripts/AnnualPublications.aspx?head=Report%20on%20Currency%20and%20Finance&fromdate=03/17/06&todate=03/19/06
The monopoly power to issue currency is delegated to a central bank in full or sometimes in part. The practice regarding the currency issue is governed more by convention than by any particular theory. It is well known that the basic concept of currency evolved in order to facilitate exchange. The primitive currency note was in reality a promissory note to pay back to its bearer the original precious metals. With greater acceptability of these promissory notes, these began to move across the country and the banks that issued the promissory notes soon learnt that they could issue more receipts than the gold reserves held by them. This led to the evolution of the fractional reserve system. It also led to repeated bank failures and brought forth the need to have an independent authority to act as lender-of-the-last-resort. Even after the emergence of central banks, the concerned governments continued to decide asset backing for issue of coins and notes. The asset backing took various forms including gold coins, bullion, foreign exchange reserves and foreign securities. With the emergence of a fractional reserve system, this reserve backing (gold, currency assets, etc.) came down to a fraction of total currency put in circulation.

Wikimedia Foundation. 2010.

### Look at other dictionaries:

• Fractional-reserve banking — is the banking practice in which banks keep only a fraction of the value of their bank notes and demand deposits in reserve and invest the balance in interest earning assets while maintaining the obligation to redeem all bank notes and demand… …   Wikipedia

• fractional reserve banking — UK US noun [U] BANKING, FINANCE ► the practice in which banks keep only a small amount of their customers money and lend the rest to other customers: »Because of the fractional reserve banking system, banks can expand our money supply several… …   Financial and business terms

• Fractional Reserve Banking — A banking system in which only a fraction of bank deposits are backed by actual cash on hand and are available for withdrawal. This is done to expand the economy by freeing up capital that can be loaned out to other parties. Most countries… …   Investment dictionary

• Criticism of fractional-reserve banking — Main article: Fractional reserve banking Criticisms of fractional reserve banking have been put forward from a variety of perspectives. Critics have included mainstream economists such as Irving Fisher,[1] Frank Knight[2] and Milton Friedman.[3]… …   Wikipedia

• Full-reserve banking — Public finance Full reserve banking is the banking practice in which the full amount of each depositor s funds are available in reserve at the bank when each depositor had the legal right to withdraw them. Full reserve banking was practiced… …   Wikipedia

• Reserve — (sometimes Reserves) may refer to:* Course reserve, library materials reserved for particular users * Dynamic reserve, the set of metabolites that the organism can use for metabolic purposes * Reserve clause, in North American professional sports …   Wikipedia

• Reserve requirement — The reserve requirement (or required reserve ratio) is a bank regulation that sets the minimum reserves each bank must hold to customer deposits and notes. These reserves are designed to satisfy withdrawal demands, and would normally be in the… …   Wikipedia

• Islamic banking — Banking A series on Financial services …   Wikipedia

• Federal Reserve System — FRB and FED redirect here. For other uses, see FRB (disambiguation) and FED (disambiguation). Federal Reserve System …   Wikipedia

• History of banking — The first banks were the merchants of the ancient world that made loans to farmers and traders that carried goods between cities. The first records of such activity dates back to around 2000 BC in Assyria and Babylonia. Later, in ancient Greece… …   Wikipedia