What is Fractional Reserve Banking? Money Creation in the Economy

Fractional reserve banking is a system where only a fraction of bank deposits are backed by actual cash on hand and available for withdrawal.

Fractional reserve banking is the standard system used by commercial banks worldwide. In this system, banks are required to keep only a specific percentage of their deposit liabilities in reserve (either in their vaults or at the central bank) and are free to lend out the remainder. This process creates money through the 'money multiplier' effect, expanding the total money supply beyond the initial base currency issued by the central bank.

The maximum amount of money the banking system can generate is defined by the formula: $M = \frac{1}{R}$, where $R$ is the reserve requirement ratio. If the Federal Reserve sets a reserve requirement of 10%, a $1,000 deposit can theoretically result in $10,000 of total money in the economy. However, if depositors lose confidence and attempt to withdraw their funds simultaneously, the bank faces a Bank Run, as it does not hold enough liquid cash to satisfy all liabilities at once.

The inherent risk of fractional reserves was demonstrated in March 2023 with the collapse of Silicon Valley Bank (SVB). SVB had invested a large portion of its 'excess' deposits in long-dated Treasuries. When interest rates rose, the value of these bonds fell. When a surge of depositors demanded their cash back, the bank was forced to sell these bonds at a loss, wiping out its equity and triggering a liquidity crisis. This highlighted the 'Duration Gap' risk that exists when a bank's liabilities (short-term deposits) are misaligned with its assets (long-term loans or bonds).