What is Fractional Reserve Banking ?

If you are entrepreneur setting up your own business, you need to understand how banking and economics work in tandem with your business to gain insights into how you can run your business profitably.

Fractional reserve banking can be explained in the following manner: Customer A deposits 100 Dollars in the Bank and the Bank accepts the deposit. The bank in turn to make profits on the deposits lends out loans totaling 1000 Dollars. Before you wonder how the bank can do this, you need to understand that unless Customer A walks into the bank one fine day and demands the entire 100 Dollars back; the bank is safe.

Further, according to the central bank requirements, banks are supposed to have cash at hand that varies from country to country.

For instance, in many countries central banks have decreed that banks must hold 25 percent of their total reserves in cash. Therefore, the bank that accepted the deposit from Customer A need to hold only 25 Dollars in the form of cash and it is free to do whatever it wants with the other 75 Dollars.

Similarly, other customers deposit money and the bank likewise loans them out to other customers. In this way, your deposit of 100 Dollars multiplies to a large amount by the system of fractional reserve banking.

In other words, banks must hold a fraction of their reserves in cash and can lend out the rest to the other customers.

Leverage, Bank Runs and the Perils of Fractional Reserve Banking

Supposing all customers who have deposited 100 Dollars want their entire money back on day based on some economic event that would have happened. Then, this situation is known as a “run on the bank” and as the bank holds only a fraction as cash, it would be in dire straits needing bailouts from the central banks.

The economic event that would have happened can be as simple as the loans that the bank made going bad or what are known as NPA’s or Non Performing Assets. The event can also be due to the value of the assets that the bank bases its loans on going down. This depreciation in the leverage or the ramping up of loans based on the value of the underlying asset is known as leverage.

Take for example, the loan that the bank would have made from the 100 Dollars deposited by customer A. Since only 25 Dollars are to be held in reserve, the bank can loan out the other 75 Dollars. If the loan is for 750 Dollars, the leverage is 10 times.

In this case, if the value of the asset depreciates by 10 percent the bank is under water as the leverage is 10 and the depreciation is 10%. Therefore, this leads to a run on the bank once news of this gets out to the depositors.

This is the situation in the United States and Europe where banks are heavily leveraged and since the assets or the homes that they used as collateral have depreciated, the banks needed to be bailed out by the governments.

Closing Thoughts

There are many who argue that fractional reserve banking is needed for the economy to grow and that the incidence of bank runs is a statistically minor occurrence. However, there are others who point to the recent troubles in the US and Europe to make the point that fractional reserve banking must be stopped if not regulated. Whichever side you are in, the basic fact remains that leverage is something that must be reined in urgently as the stability of the banking sector is at risk.

Since entrepreneurs are depositors and borrowers at the same time, they must know these terms and concepts before setting up businesses. The subsequent articles discuss how the changes in the real economy affect the operations of businesses and their implications for businesses and the people who run them.