Understanding Fractional Reserve Banking: Traditional Finance vs. Cryptocurrency Models

What is Fractional Reserve Banking?

Fractional reserve banking is a financial system that allows commercial banks to generate profit by lending out a significant portion of their customers’ deposits, while only maintaining a small percentage of those deposits as actual reserves available for withdrawal. This banking mechanism effectively creates money “out of thin air” by utilizing a percentage of customer bank deposits as the foundation for new loans.

In this system, banks are required to maintain only a minimum percentage (a fraction) of deposited money in their financial accounts as reserves, enabling them to lend out the remainder. When a bank issues a loan, both the institution and the borrower count these funds as assets, effectively doubling the initial amount in economic terms. This money is then reused, reinvested, and repeatedly lent out, generating a multiplier effect in the monetary supply. This is precisely how fractional reserve banking “creates new money” within the economic system.

Loans and debt are integral components of fractional reserve banking and often require central banks to put new funds into circulation so that commercial banks can service withdrawals. Most central banks also function as regulators determining, among other things, minimum reserve requirements. This banking system is the predominant model used by national financial institutions worldwide, particularly in the United States and many other free-market economies.

The Historical Development of Fractional Reserve Banking

Fractional reserve banking emerged around 1668 when Sweden’s Riksbank (Sveriges) became the world’s first central bank, though more rudimentary forms of fractional reserve banking were already in practice. The concept that silver deposits could be amplified and grown, thereby stimulating the economy through lending, quickly gained popularity. It was considered logical to utilize available resources to encourage spending rather than keeping them secured in vaults.

Once Sweden took steps to formalize the practice, the fractional reserve structure was rapidly established and expanded. Two central banks were subsequently created in the United States, the first in 1791 and the second in 1816, though neither lasted. In 1913, the Federal Reserve Act established the Federal Reserve Bank of the United States (FED), which now serves as the U.S. central bank. This financial institution aims to stabilize, maximize, and oversee the economy in relation to prices, employment, and interest rates.

How Fractional Reserve Banking Works

When a customer deposits money into their bank account, that money is no longer directly owned by the depositor. The bank becomes the owner and, in exchange, provides the customer with a deposit account they can access. This arrangement requires banks to ensure customers can access the entirety of their deposits upon request, in accordance with prevailing banking rules and procedures.

However, when the bank takes possession of the deposited money, it doesn’t actually retain the full amount in the customer’s account. Instead, it reserves only a small percentage of the deposit (the fractional reserve). This reserve amount typically varies between 3% and 10%, with the remaining funds being used to issue loans to other customers.

The following simplified examples demonstrate how loans can generate money through the multiplier effect:

1. Customer A deposits $50,000 in Bank 1. Bank 1 lends Customer B $45,000
2. Customer B deposits $45,000 in Bank 2. Bank 2 lends Customer C $40,500
3. Customer C deposits $40,500 in Bank 3. Bank 3 lends Customer D $36,450
4. Customer D deposits $36,450 in Bank 4. Bank 4 lends Customer E $32,805
5. Customer E deposits $32,805 in Bank 5. Bank 5 lends Customer F $29,525

With a required fractional reserve of 10%, the initial deposit of $50,000 has expanded to $234,280 in total available currency, which represents the sum of all customer deposits across respective institutions. While this is a highly simplified example of how fractional reserve banks generate money through the multiplier effect, it illustrates the basic principle in concrete terms.

Note that this process is based on the principal debt amount (the sum on which loan interest is calculated). Deposit accounts represent money that banks owe to their customers (liabilities), while interest-bearing loans generate additional money for banks because they constitute assets. In simple terms, banks profit by generating more assets in their loan accounts than liabilities in their checking (deposit) accounts.

The Risk of Bank Runs

What happens if all fund holders at a particular bank decide to appear simultaneously and withdraw all their money? This scenario is called a “bank run” because, as the bank is only required to hold a small fraction of its customers’ deposits in reserve, they would likely collapse due to their inability to meet financial obligations.

For the fractional reserve banking system to function properly, it is imperative that not all depositors rush to banks simultaneously to withdraw or access all their funds. Although bank runs have occurred historically, this is generally not the normal behavior of customers. In fact, users typically only attempt to withdraw all their money if they believe the bank is experiencing serious problems.

In the United States, the Great Depression stands as a notorious example of the catastrophe that can result from mass withdrawals. Today, the reserves maintained by banks constitute one of the mechanisms used to minimize the chances of such an event recurring. Some banks maintain reserves above the required minimum for this purpose, to better respond to customer demands and ensure access to funds in deposit accounts.

Advantages and Disadvantages of Fractional Reserve Banking

While banks enjoy most of the benefits of this highly lucrative system, a small portion of the system’s advantages also reaches banking customers who earn interest on their deposit accounts. Governments are also part of this mechanism and often argue that fractional reserve banking systems encourage spending and ensure economic stability and growth.

However, many economists believe the fractional reserve system is unsustainable and even quite risky, especially considering that the current monetary system implemented by most countries is actually based on credit/debt rather than real money. Our economic system is founded on the principle that people trust both banks and fiat money, established as legal tender by governments.

Fractional Reserve Banking vs. Cryptocurrency Systems

Unlike the traditional fiat currency system, Bitcoin was created as a decentralized digital currency, giving rise to an alternative economic framework that operates in a fundamentally different manner.

Like most cryptocurrencies, Bitcoin is managed through a distributed network of nodes. All data is protected by cryptographic proofs and recorded in a distributed public ledger called blockchain. This means there is no need for a central bank and no authority in charge of the system.

Additionally, Bitcoin’s issuance is limited, meaning no more units will be generated once the maximum supply of 21 million units is reached. Therefore, the context is entirely different, and fractional reserve banking as we know it does not exist in the world of Bitcoin and cryptocurrencies.