Fractional-reserve banking
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Fractional-reserve banking refers to a financial system "in which some fraction of the deposits can be used to finance profitable but illiquid investments." [1]
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History
At one time, people deposited gold coins and silver coins at goldsmiths for safe keeping, receiving in turn a note for their deposit. Once these notes became a trusted medium of exchange an early form of paper money was born, in the form of gold certificates and silver certificates.
As the notes were used directly in trade, the goldsmiths noted that people would never redeem all their notes at the same time, and saw the opportunity to issue new bank notes in the form of interest paying loans. These generated income—a process that altered their role from passive guardians of bullion charging fees for safe storage, to interest-paying and earning banks. Fractional-reserve banking was born. When creditors (the owners of the notes) lost faith in the ability of the bank to exchange their notes back into coins, many would try to redeem their notes at the same time. This was called a bank run and many early banks either went into insolvency or refused to pay up.
Purpose and function
The Federal Reserve gives a summary of why fractional reserve banking is used and what its effects are:
- The fact that banks are required to keep on hand only a fraction of the funds deposited with them is a function of the banking business. Banks borrow funds from their depositors (those with savings) and in turn lend those funds to the banks’ borrowers (those in need of funds). Banks make money by charging borrowers more for a loan (a higher percentage interest rate) than is paid to depositors for use of their money. If banks did not lend out their available funds after meeting their reserve requirements, depositors might have to pay banks to provide safekeeping services for their money. For the economy and the banking system as a whole, the practice of keeping only a fraction of deposits on hand has an important cumulative effect. Referred to as the fractional reserve system, it permits the banking system to “create” money.[2]
How it works
A deposit at a bank is essentially a loan to the bank which the bank in turn loans out to someone else or spends elsewhere. The nature of fractional-reserve banking is that there is only a small number of funds available at the bank compared to the total amount of deposits. The reason people deposit funds at a bank is to store savings or to make an investment. One important aspect of fractional-reserve banking is that the depositor still has a claim to their funds even though the funds were already spent by the bank somewhere. The depositor can usually demand a complete withdrawal from their deposit and receive the funds in full. Fractional-reserve banking works because:
-
- Only a minority of people will actually choose to do this at any given time since people usually choose to keep their funds in the bank for a prolonged period of time
- There are usually enough reserves in the bank to handle withdrawals
If too many depositors were to demand withdrawals then the bank will go bankrupt. This is known as a bank run and is the major risk factor in fractional-reserve banking.
Cumulative effect
The process of fractional-reserve banking leads to a cumulative effect of money creation by banks[2]. In short, there are two types of money in a fractional-reserve banking system[3][4]:
-
- central bank money (physical currency)
- commercial bank money (money created through loans)
When a loan is supplied with central bank money, new commercial bank money is created. As a loan is paid back, the commercial bank money disappears from existence.
The table below displays 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. An initial deposit of $100 of central bank money is lent out 10 times with a fractional-reserve rate of 20%. This means that of the initial $100, 20 percent of it, or $20, is set aside as reserves while the remaining 80 percent, or $80, is loaned out. The recipient of the $80 then spends that money. The receiver of that $80 then deposits it into a bank. The bank can then sets aside 20 percent of that $80, or $16, as reserves and lends out the remaining $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 it then has more money to lend out.
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 borrowers may choose to hold cash, and there may be delays or frictions in the process.[5]
| Table:[6] Fractional-Reserve Lending Cycled 10 times with a 20 percent reserve rate (sources: The New York FED,[7] Bank for International Settlements[3]) | ||||
|---|---|---|---|---|
| individual bank | amount deposited | amount loaned 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 deposited: | total amount loaned out: | total reserves + last amount deposited: | ||
| 457.05 | 357.05 | 100 | ||
| commercial bank money created + central bank money: | commercial bank money: | central bank money: | ||
| 457.05 | 357.05 | 100 | ||
Although no new money was physically created from 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 amount of commercial bank money that can be created is $400.
For an individual bank, the deposit is considered a liability whereas the loan it gives out and the reserves are considered assets. The deposit will always be equal to the loan plus the reserve, since the loan and reserve are created from the deposit. When a loan is paid back, commercial bank money is erased from existence. This is apparent from the table. As a loan is paid back, the total loans, and therefore the total commercial bank money, decreases. A simple demonstration of the destruction of money occurs if the process in the table is processed backwards. If the last deposit is withdrawn and given to the person who owes the last loan, that last loan will be erased. Continue this process backwards up through the table and the total loans will reach zero, the total deposits will decrease to 100, and total reserves will decrease to zero. The quantity of central bank money remains constant throughout the entire process. (Unless new central bank money is physically created, of course, but that is outside the scope of this simple example.)
The reserves are not allowed to be used to fund any more loans. The reserves cannot be spent until the loan they back up is paid back. If someone defaults on a loan, the reserves have to remain as reserves until the bank can come up with money to cancel the commercial bank money created by the loan.[citation needed]
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[3]. The value of commercial bank money comes from the fact that it can be exchanged at a bank for central bank money[3][4].
Money multiplier
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[8]:
Example
For example, with the reserve ratio of 20 percent, this reserve ratio, R, can also be expressed as a fraction:
So then the money multiplier, m, will be calculated as:
This number is multiplied by the initial deposit to show the maximum amount of money it can be expanded to.
Reserve requirements
The reserve requirements are intended to prevent banks from:
- generating too much money by making too many loans against the narrow money deposit base;
- having a shortage of cash when large deposits are withdrawn (although the reserve is a legal minimum, it is understood that in a crisis or bank run, reserves may be made available on a temporary basis).
The money creation process is affected by the currency drain ratio (the propensity of the public to hold banknotes rather than deposit it 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.[9] In practice, the actual money multiplier varies over time, and may be substantially lower than the theoretical maximum.[10]
Financial ratios
In addition to reserve requirements, there are other financial ratios affect how many loans a bank can fund. The capital ratio is one type of ratio. It is also important to note that the term 'reserves' in the reserve ratio generally does not include all liquid assets.[citation needed]
Effects of an increased money supply
Fractional reserve banking involves the issue of commercial bank money. According to the quantity theory of money, the expansion of the money supply leads to more money with the same amount of goods, which leads to inflation. Some monetarists believe that the exchange rate or purchasing power of the monetary unit is governed by the quantity of money, including demand deposits and notes, and therefore view fractional reserve banking as a potential cause of inflation. Most schools of economics recognize the link between money supply and inflation; many economists, however, consider the issue of money through the banking system as 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).
Quantity theorists may either be hostile to fractional reserve banking or supportive of minimum reserve ratios and other government controls on the quantity of money created by commercial banks. The process with which commercial banks practice fractional-reserve banking is explained at deposit creation multiplier.
Limitations for loan creation
The amount of loans that can be given out and thus the amount of commercial bank money that can be created depends on what the bank is permitted to do. In a free banking system, the demand for loans is contingent on the interest rates which are fixed by the lenders who compete against each other. In regulated systems, governments have created central banks that influence interest rates and thus the money supply through the monetary transmission mechanism.
Free banking
Free banking is a theory of banking in which commercial banks and market forces control the provision of banking services. Under free banking, government central banks and currency boards do not exist, and banking-specific government regulations are either non-existent or not as strict.
Government regulated systems
Fractional-reserve banking is the basis for many financial systems throughout the world. 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[11].
Central banks
Government controls and bank regulations related to fractional-reserve banking have generally been 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:
- Minimum required reserve ratios (RRRs)
- Minimum capital ratios
- Government bond deposit requirements for note issue
- 100% Marginal Reserve requirements for note issue, such as the Peels Act 1844 (UK)
- Sanction on bank defaults and protection from creditors for many months or even years, and
- Central bank support for distressed banks, and government guarantee funds for notes and deposits, both to counter-act bank runs and to protect bank creditors.
Use of money multiplier
The use of the money multiplier as a tool of monetary policy is declining, as the money multiplier has changed over time and can usually not be directly influenced by central banks: privately owned banks may have different target levels of liquidity and may not be able to control directly the level of deposits attracted or feasible lending opportunities.[12]
Liquidity management for a bank
To avoid defaulting on its obligations, the bank must maintain a reserve ratio greater than zero. In practice this means that the bank sets a reserve ratio target and responds when the actual ratio falls below the target by:
- Selling or redeeming other assets,
- Restricting investment in new loans,
- Borrowing funds (whether repayable on demand or at a fixed maturity), or
- Issuing additional capital.
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:
- Demand deposits with other banks
- High quality marketable debt securities
- Committed lines of credit with other banks
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.
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 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.
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 (legal tender) cash held by the bank is $201m and the demand liabilities of the bank are $25482m, for a (legal tender) cash reserve ratio of 0.79%.
Other financial ratios
The key financial ratio used to analyse fractional-reserve banks is the cash reserve ratio, which is the ratio of cash reserves to demand deposits and notes. However, other important financial ratios are also used to analyse the bank's liquidity, financial strength, profitability etc.
For example the ANZ National Bank Limited balance sheet above gives the following financial ratios:
- The (legal tender) cash reserve ratio is $201m/$25482m, i.e. 0.79%.
- The central bank notes/balances reserve ratio is $3010m/$25482m, i.e. 11.81%.
- The liquid assets reserve ratio is ($201m+$2809m+$1797m)/$25482m, i.e. 18.86%.
- The equity capital ratio is $8703m/107787m, i.e. 8.07%.
- The tangible equity ratio is ($8703m-$3227m)/10787m, i.e. 5.08%
- The total capital ratio is ($8703m+$2062m)/$10787m, i.e. 9.98%.
Clearly, then, it is very important how the term 'reserves' is defined for calculating the reserve ratio, and 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 |
Criticism
Although fractional-reserve banking is near universal, it is not without criticism. The primary criticisms relate to the financial risk note holders and depositors bear, and the impact bank notes and demand deposits have on the stock of money, and potentially its value (that is, the effect on inflation and the exchange rate). One proposed alternative to fractional reserve banking is full-reserve banking.
Business cycle
Fractional-reserve banking, by expanding the money supply, implies that interest rates will be different than what they would be in a full-reserve system. Austrian School economists point to the role of the interest rate as the price of investment capital, guiding investment decisions. In their view, the "natural" (free of government influence) interest rate reflects the actual time preference of lenders and borrowers. Government control of the money supply through central banks and regulations allowing fractional-reserve banking disturbs this equilibrium such that the interest rate no longer reflects the real supply of and demand for investment capital. Austrian School economists conclude that, if the interest rate is artificially low, then the demand for loans will be higher than the actual supply of willing lenders, and if the interest rate is artificially high, the opposite situation will occur. This misinformation leads investors to misallocate capital, borrowing and investing either too much or too little in long-term projects. Periodic recessions, then, are seen as necessary "corrections" following periods of fiat credit expansion, when unprofitable investments are liquidated, freeing capital for new investment. The business cycle theory was recognized by the Royal Swedish Academy of Sciences, which awards the Nobel Prize in Economics[1], but is not universally accepted; at least one mainstream economist, Paul Krugman, considered it unworthy of serious study.[13] A few Austrian School economists, such as Pascal Salin, also suggest that a full-reserve banking system should not be enforced and rather simply root for free banking.
Risk
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. 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).
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:
- Opponents of fractional reserve banking who insist that notes and demand deposits be 100% reserved;
- 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);
- 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,
- 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.
Incompatible with a gold standard
Some critics of irredeemable fiat currency see fractional-reserve banking as being incompatible with a return of the gold standard, despite the fact that most countries that used a gold standard in the twentieth century had commercial fractional reserve banking. In countries where commercial banks do not issue bank notes, this concern does not exist; in some countries and territories where banks issue notes (such as Hong Kong), banks issue notes but most hold an equal quantity of assets issued by the monetary authority.
However, other critics of irredeemable fiat currency, from the free banking school, support fractional-reserve banking, and view the threat to the gold standard as originating from central banking and government controls on the formation and winding-up of banks and the business of banking.
Inadequate government regulation
Critics of current bank regulations argue that:
- Minimum reserve ratios put reserves beyond reach in a time of need;
- Minimum capital ratios are poor regulators of financial risk, as they ignore other portfolio risk drivers such as scale and diversification and come at a heavy compliance cost;
- Central bank support and government protection of creditors creates moral hazard and socializes credit risk.
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