How Does Fractional Reserve Lending Work?

March 2023 has been a tumultuous month for the banking sector, with Silicon Valley Bank (SVB) and Signature Bank experiencing major failures, marking the largest bank collapse since the 2008 crisis. The root cause of these failures was the fractional reserve banking behavior these institutions had engaged in

As part of their banking practices, both Silvergate and SVB had invested a portion of their deposits in the US Treasuries, keeping only a fraction of their deposits in reserve.

In fractional reserve banking, banks hold only a fraction of the total amount of deposits they have on their balance sheets in reserve while lending out the rest to borrowers in the form of loans or investing in other assets. The reserve requirement is the minimum amount of cash or deposits a bank must keep on hand to meet customer withdrawals and other obligations.

Unfortunately, the value of these investments in government bonds declined significantly due to the Federal Reserve's increase in interest rates. Consequently, these banks were forced to sell some of their assets at a considerable loss to satisfy customer demands for withdrawals, leading to a widespread bank run as customers panicked and withdrew their funds in droves.

While SVB had $209 billion in assets and Signature had $110 billion, these failures demonstrated that even large institutions could be susceptible to bank runs if customers panic and start pulling their deposits.

So, what exactly is this practice most commonly used in the modern banking system? Let's understand it in detail!

Understanding Fractional Reserve Lending

Fractional reserve lending is commonly used in fractional reserve banking. In this banking practice, banks keep only a fraction of the deposits made by their customers as reserves and lend out the remaining amount. For example, if a bank has a reserve requirement of 10% and receives a deposit of $100, it will keep $10 as reserves and lend out $90.

This system basically allows banks to create money out of thin air by lending more money than they actually have in reserves. And as long as they have enough reserves to meet the reserve requirement set by the central bank, they can continue to lend money and make a profit from the interest charged on loans.

When opening a bank account, you typically agree to a contract that allows the bank to use a portion of your deposited funds to provide loans to other customers. However, this doesn't restrict your access to the deposited money, as you can still withdraw the full balance of your account. But if you wish to withdraw an amount exceeding the percentage held by the bank, they may need to source additional funds to fulfill your request.

Fractional reserve lending works because not all depositors withdraw their money simultaneously. Hence, banks only need to keep a fraction of deposits as reserves to meet the demands of those who do. However, if too many depositors try to withdraw their money at once, a bank may run out of reserves and become insolvent, causing a bank run, as we saw in the case of SVB and Silvergate.

Fractional reserve lending is a crucial part of the modern banking system and is regulated by central banks to ensure the stability of the financial system. Central banks set reserve requirements for banks and use tools like open market operations to control the money supply and prevent inflation.

In the United States, the Federal Reserve regulates fractional reserve lending and sets reserve requirements for member banks. These reserve requirements determine the percentage of deposits banks hold in reserve and cannot lend out. The reserve requirements are designed to ensure that banks have enough cash on hand to meet the demands of their depositors and prevent bank runs.

Fractional Reserve Lending Process

A key component of fractional reserve banking, Federal Reserve lending is the practice of banks keeping only a fraction of the deposits made by their customers as reserves and lending out the rest.

The process of fractional reserve Lending starts when customers deposit money in their bank accounts. The bank keeps a certain percentage of these deposits as reserves, as required by the central bank.

The bank holds the reserves either in cash or as deposits with the central bank. The percentage of deposits banks are required to hold as reserves are called the reserve requirement ratio.

The reserve requirement ratio is determined by the central bank and varies from country to country. The US Fed initially set reserve requirements at 13%, 10%, and 7%, depending on the type of bank, in 1971, with ratios fluctuating between 8% and 10% over time. As of March 2020, reserve requirements were eliminated entirely and replaced by Interest on Reserve Balances (IORB) as an optional incentive for banks to hold reserves.

The bank lends out the remaining portion of the deposits as loans to individuals, businesses, or other entities. The bank charges interest on these loans, which is how it generates revenue.

When the borrowers receive the loans, they typically deposit the funds in their bank accounts. This increases the amount of deposits held by the bank. As such, the bank recalculates its reserves based on the increased deposits and the reserve requirement ratio. If the bank's reserves fall below the required ratio, it must acquire more reserves by attracting deposits or borrowing from the central bank.

The bank then repeats the process of lending out the remaining portion of the deposits as loans and generating revenue from interest.

History of Fractional Reserve Lending

Fractional reserve lending has a long history dating back to ancient civilizations, where banks and moneylenders kept reserves of gold or silver and issued receipts that could be used as a form of payment. These receipts were essentially the first paper money.

In Europe, during the Middle Ages, goldsmiths often acted as bankers, storing their clients' gold and issuing paper receipts in exchange. The goldsmiths discovered that they could issue more receipts than they had gold on hand, as not all clients would come to claim their gold simultaneously. This led to an early form of fractional reserve lending and the creation of additional money in circulation.

The fractional reserve banking system that we know today first began to develop in the early 1800s. The practice became more widespread in the 19th century. However, the system was not without its problems, as bank failures and bank runs were common due to the lack of regulation and oversight.

To address these issues, the Federal Reserve System was established in 1913 to regulate the banking industry and promote financial stability. The Fed was given the authority to set reserve requirements for banks and to provide lender-of-last-resort support during times of financial crisis.

Despite its history of controversy, fractional reserve lending remains a fundamental component of modern banking systems. Today, most countries use some form of fractional reserve lending as the basis for their financial systems.

Fractional Reserve Lending vs. Other Types of Lending

Fractional reserve lending is just one of several types of lending practiced by financial institutions.

One type of lending is full reserve lending, and under this system, banks are required to hold 100% of deposits as reserves and can only lend out what they have on hand. This system eliminates the risk of bank runs but limits the ability of banks to create money and provide loans to customers.

Peer-to-Peer (P2P) lending is another one where lending platforms connect individual borrowers with individual lenders, bypassing traditional banks. P2P lending can offer lower interest rates to borrowers and higher returns to lenders and doesn't involve any regulatory oversight.

Yet another one is Islamic Finance, where lending is based on the principles of risk-sharing and profit-sharing rather than charging interest. This system prohibits charging interest and instead relies on investments and shared profits.

Fractional reserve lending is unique in that it allows banks to create new money by lending out more than they have in reserves, which can stimulate economic growth but also increases the risk of bank runs and financial instability. However, it is crucial, as it provides liquidity to the economy and allows banks to provide loans and other financial services to individuals and businesses.

Advantages and Disadvantages of Fractional Reserve Lending

Fractional reserve lending offers several benefits that make it popular in the modern financial system. For starters, it allows banks to create new money by lending out more than they have in reserves, which increases the money supply and makes more funds available for loans and other financial services.

Fractional reserve lending can stimulate economic growth by giving individuals and businesses access to credit, which they can use to invest in new projects, expand their operations, and create jobs.

This form of lending also allows banks to respond quickly to changes in demand for loans and other financial services, which can help smooth out economic fluctuations.

Not to mention, Fractional reserve lending can be a profitable business model for banks, as they earn interest on loans while only having to hold a fraction of the funds in reserve.

But while having several advantages, fractional reserve lending is not without its faults. It can especially be risky, as banks may not have enough reserves on hand to meet depositors' demands in the event of a bank run. More importantly, fractional reserve lending can contribute to financial instability, as the creation of new money can lead to inflation and asset bubbles, which can cause economic booms and busts.

It can further contribute to the unequal distribution of wealth, as those with access to credit and who can invest in new projects may benefit more than those who do not have access to them. Another downside of fractional reserve lending is that it can create a moral hazard, as banks may take on too much risk knowing that they can rely on government support in the event of a crisis.

This goes on to show that fractional reserve lending is a complex system with both advantages and disadvantages. This is why fractional reserve lending requires careful management and regulation to minimize risks and promote financial stability.

Criticisms of Fractional Reserve Lending

Critics of fractional reserve lending argue that it creates an unstable financial system by exposing banks and depositors to bank runs and insolvency risks. It also has been argued that it allows banks to create money out of thin air and contributes to inflationary pressures in the economy.

Additionally, some argue that it can lead to a misallocation of capital and encourage excessive risk-taking by banks. Not to mention, it is inherently unfair, as it allows banks to profit from the use of depositors' money without fully compensating them for the risk involved.

For instance: British bank Northern Rock, which specialized in mortgage lending, relied heavily on wholesale funding to finance its operations, and as a result, it held relatively low levels of liquid assets. When the global financial crisis hit in 2007, Northern Rock could not roll over its short-term funding and faced a run on deposits. As a result, the bank had to be nationalized by the UK government to prevent a collapse.

US-based IndyMac, which focused on subprime mortgage lending, much like Northern Rock, relied on short-term funding from the wholesale market and held relatively low levels of liquid assets. When the US housing market collapsed in 2008, IndyMac could not meet depositors' demands and was seized by federal regulators.

Another example is Cyprus Popular Bank, one of Cyprus's largest banks with significant exposure to Greek government bonds. When the Greek debt crisis erupted in 2013, the bank suffered significant losses and could not meet the depositors' demands. The bank was eventually wound down, with depositors losing a substantial portion of their savings.

These examples illustrate the risks associated with fractional reserve banking and the potential for bank failures when banks take on excessive risk or rely too heavily on short-term funding.

The Bottom Line

In conclusion, fractional reserve lending is a banking practice that allows banks to create credit and stimulate economic growth by lending out a portion of depositors' funds. While this practice has benefits, such as providing credit to individuals and businesses, it also exposes banks and depositors to the risk of bank runs and insolvency.

Additionally, fractional reserve lending can contribute to inflationary pressures, encourage excessive risk-taking by banks, and is inherently unfair to depositors.

Ultimately, the debate over fractional reserve lending highlights the need to balance promoting economic growth and maintaining a stable and fair financial system.