LeoGlossary: Fractional Reserve Banking

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Fractional Reserve Banking is the banking system that most of the world utilizes. It is often tied to the central bank monetary system.

Individuals who deposit money into a bank are agreeing, when the account is opened, to allow the lender to utilize the funds to make loans. This is how banks make money.

Many accounts earn the depositors interest. The way the bank is able to pay this is to put the capital work and earn a return. This is often done by paying short term rates to depositors while lending out or buying securities for the long term. Interest rates on longer term assets tend to provide a higher return.

The amount of money the banks have to keep available for withdrawal is set by regulation. This is often the central bank although organization such as the Office of the Comptroller of the Currency (OCC) can require banks to increase their reserves.

Banks Options

When it comes to the investments banks can make, there are only a few choices. The first is to lend the money out. Commercial banks provide mortgages, car loans, and other lending services to businesses and individuals. Community banks often handle a great deal of the funding of local economies through its support of small businesses.

Making loans can provide the banks with the highest return. This is a rate usually above other assets such as US Treasuries (or any sovereign debt). It is a move that does carry a greater degree of risk. Not all borrowers pay their loans back. Defaults are a fact of life for banks. For this reason, bad debt levels are watched by both the banks themselves and the regulators.

If lending is not chosen, the investment choices in most countries are narrowed down to buying government approved securities. In the United States, there are two choices:

Banks purchase these securities which generates yield on the deposits they have. This provides them with the cash flow necessary to pay the interest on loans. Once concern that depository institutions should have is liquidity. Since securities can be non-liquid, it is important to match maturity with expected liquidity requirements.

Bank Accounting

To individuals and most businesses cash is an asset on the balance sheet. The same holds true for banks. One difference is that when cash is received as a result of a deposit, that is a liability. The bank owes the money back to the depositor along with the agreed upon interest.

We see the same situation with loans. To the borrower, a loan is a liability, something requiring payment. The bank is on the other side of the transaction, being the counterparty in the deal. Under this situation, the loans are an asset on the bank's balance sheet.

As a bank makes more loans, its balance sheet expands. This allows it to provide more financial services as it has access to more money. The banking system is many layers of lending, a fact that makes asset accumulation important.

Increasing the number of demand deposits provides the bank with more resources. While this increases the liabilities, it should enhance the asset side. A bank's profitability comes from borrowing (from depositors) at a lower rate than it lends out or gets from investing.

Traditional Reserves

The historical concept of a bank was that it was a place to store money. Under this idea, a deposit was cash. When most economies were centered around banknotes, commerce occurred through this payment mechanism. Having a lot of currency around in this form was not a safe approach.

Here is where banks entered. Depositors went to the bank with their cash. The bank stored the cash in the vault, offering safekeeping. When fractional reserve banking was introduced, the reserve percentage was mostly based upon physical cash the banks were holding.

This concept is exemplified in the classic film It's A Wonderful Life. There was a scene where George Bailey (Jimmy Stewart) was trying to avert a bank run by giving some money to appease the depositors. He even used his family's vacation fund to avert the crisis.

Bank runs are a result of fear of solvency going through the depositors. Since there is not 100% of the cash backing the deposits, people get worried they will not get their money back. This was usually before the days of FDIC and other such programs trying to provide confidence to depositors.

One of the ways regulators sought to appease the depositing public was to set reserve requirements for the commercial banks. This meant that a certain level of cash was to be on hand at all times.

Non-Physical Deposits

As money changed, so did the concept around fractional reserve lending.

The idea of a reserve requirement was easy to follow when deposits were done with cash. Over the last few decades, the number of transactions occurring in electronic form skyrocketed. This means that banks main service was not to provide a vault for physical currency. Instead, it became the maintainer of the ledger. Since cash is such a minor percentage of the monetary system, both central bank and commercial bank money because ledger based.

This was offset by the fact that physical cash is not the main form of payment when loans are created. Here we see settlement taking place using check or wire.

Fractional reserve banking is still applicable. The only difference is that, instead of dealing with cash as the intermediary for the transactions, they are just a function of accounting.

Since settlement is not done using cash, within the central bank monetary system, inter-bank ledgers are crucial. Here is where reserves and short term funding come into play.

When deposits are moved from one bank to another, this is an accounting function (some term this numbers on a screen). No money is transferred although a credit and debit do appear in each depository account.

To settle, payment is required. If a bank does not have enough in reserves to make up for the deficit, it has to enter the Repo market to get a loan. Under this scenario, securities on the balance sheet are put up as collateral against a short term loan. This provides the bank with the liquidity it needs to settle.

As long as there is a liquid market for the security, it is accepted as collateral. U.S. Treasuries are the most valuable for this purpose since they have the largest market. With this, however, there are times when certain notes or bonds are off-the-run. This means there is little market for them. When it comes to collateral, T-Bills are the highest form since they are always on-the-run, providing a liquid market.

The Lesson of Silicon Valley Bank

The demise of Silicon Valley Bank in early 2023 is an example of what can happen with the banking system.

Here was a bank that has hundreds of billions of dollars in assets under management. It also have a strong real estate portfolio on its balance sheet, making a lot of commercial loans.

With so much value in assets, how could the bank go under. This was nothing more than a liquidity issue.

Like most banks, SVB invested in long-dated securities, seeking to get maximum yield. When a bank run started, deposits were moved out to other banks. This meant the Fed Wire system was pumping SVB with outgoing wires. Being the 21st century, this meant that numbers were shifted on screens.

The problem arose with settlement. All receiving banks were due either US dollars or reserves from SVB. It had neither to cover the money pulled out.

At the root of this was the Federal Reserve raising interest rates in a rapid fashion. Due to the extent of the move, long dated bonds found demand evaporating. Also, as the yield rose, the market value was far below par. Some of the bonds were trading for 60% less.

This meant counterparties were unwilling to accept these securities as collateral. Since the bank did not have a lot of securities found at the front end of the yield curve, it has no choice but to start trying to sell what it could to raise the capital needed. It was unsuccessful with this approach and ended up going under.

This is an example of how financial institutions can have a lot in securities but lack liquidity.

The Money Supply

Fractional reserve banking plays a huge part in the money supply of a nation.

As society shifted to digital currency, the impact of the central bank in terms of the ability to inject money directly into the economy was hindered. The "money printing" of the Fed is limited to banknotes and reserves. Since we do not use much in the way of cash, and reserves can only be held by those with master accounts at the Fed, neither have much impact upon the general economy.

Commercial banks, on the other hand, have a huge influence. The money supply expands when a bank loan is made. Here we take a portion of the existing money and use it to lend. The money supply increases since only a portion of the loan is made with existing currency (USD for the sake of discussion).

For example, under normal lending requirements, to make a $300,000 loan, a bank might have to put up $30,000 with the other $270,000 being created. We can see the expansion.

The money supply contracts when borrowers pay principal on the loan or default. This is the elasticity of the money supply.

What results is the commercial banks are the ones who truly determine the inflation or deflation of the money supply. Central banks seek to influence with their monetary policy yet are limited in what they can do.


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