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Fractional-Reserve Banking

February 1st, 2010

Fractional-reserve banking is a type of banking where the bank only needs to keep a fraction of their actual deposits on premises. Almost every bank operates under this type of system because this is what allows banks to generate money. For example a bank might loan out deposit money in order to get interest paid back to them on those loans. Full-reserve banking is a system where banks must hold all their deposits and not lend out their funds.

Some form of fractional-reserve banking has been practiced for a very long time in the banking industry. The way fractional-reserve banking works is that the bank essentially borrows from its depositors to offer loans to people who apply for them. Banks may also choose to invest deposited funds in various ways. If you bank in an institution which uses the fractional-reserve system, this means that you are indirectly funding the loans and investments made by the bank; so if you bank at the same institution which administers your mortgage, you could say that you loaned yourself some of the money!

Banks take customer deposits and make money on them usually by lending out that money to individuals or small businesses. This allows the bank to pay you interest on your deposit accounts. Fractional-reserve banking is what allows banks to make as much money as they do.

Fractional-reserve banking does mean that some banks might not have much liquidity. Banks aren’t required to have all deposits at hand, but they must redeem any money a banking customer may want. For example if someone closes their checking account, the bank must come up with the cash for the customer’s account. If a large enough percentage of banking customers ask for their money all at once, the bank could be in serious trouble.

Banks can get into further trouble when their investments default on their loans. When a customer defaults the bank loses that money and has to find ways to recoup that loss, but if they can’t they just have to eat it. Too many bad loans can cause some banks to go bankrupt.

The Federal Reserve Bank is the government agency set to oversee fractional-reserve banking. In addition the FDIC insured deposits for up to $250,000 in case any banks make too many bad loans and go under.

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