This is my second post on economic stuff. Just looking to start good conversation as I enjoy discussing and sharing what I know. Hope it's as well received as I intend.
Fractional-reserve banking is the practice whereby a bank accepts deposits, makes loans or investments, and holds reserves that are equivalent to a fraction of its deposit liabilities. Reserves are held at the bank as currency, or as deposits in the bank's accounts at the central bank. - Wikipidia
Having said that.....The US no longer uses a Fractional Reserve System (at least as most people understand it and most writings explain it) as a way to constrain the creation of new money in the banking system. This is because banks are no longer constrained by reserves on hand (cash) in order to make new loans (the real constraint is based on the banks capital held at the Fed). Banks no longer lend customer deposits to other customers, but instead banks lend reserves to each other at the end of each day.
So, if a bank has $10 it can make $100 in new money and meet it’s reserve requirement. But what if a customer comes in and wants to borrow $200? No problem, the bank makes the loan and than at the end of the day borrows and additional $10 from another bank (so now it has $20) who have “excess reserves”. If for some reason the money isn’t available to borrow from another bank, the Fed can lend it, though this does not happen very often as the Fed charges a higher rate.
The system we have today appears, functionally speaking to look and act very much the same as the system in place during the gold standard, however there are subtle and importation differences.
Banks utilize double entry accounting and create money from nothing when creating loans, but banks also create a debt that matches the money created dollar for dollar which is a liability of the bank. The borrower is responsible for repaying the bank the full amount of the loan plus interest, the bank is responsible for removing the liability from its books that was used to create the loan. The banks gross profit is the interest. If the borrower defaults on a loan, the bank must use it’s on capital to remove the liability from it’s books. If too many people default and the banks capital account drops to zero and it has no other assets to sell or borrow against, then the bank becomes insolvent.
To understand the difference between today’s system and system in the past, here is a simple example. If you borrow $1 from a freind (who only has $1) then your friend’s “position” moves from $1——>$0. In turn your position moves from $0—→$1.
So how is a bank different?
When a bank creates money from nothing and lends it to you, it looks like this:
The banks position moves from $0—→ -$1 and the borrowers position moves from $0—→$1
Now in the first example when your freind repays the loan your position looks like this:
$0+$1=$1 so you have $1
The banks position looks like this:
Banks in the past operated much like borrowing from a friend in that the banks had to have the money to lend or, more precisely, a “fraction” of it, hence the term “Fractional Reserve”.
In the first example if your friend did not pay you back, you wouldn’t owe anything to anyone, but when a bank isn’t repaid, the bank must still repay the loan or they have “negative” money on their books. When “negative” money exceeds the value of the banks capital account, the bank is insolvent.
So, while banks are required to hold reserves, the reason for this has shifted from a constraint on lending to a part of a process by which the Fed controls interest rates.
The Fed sets a “target rate” which it attains by adding or removing money from the banking system which in turn affects the level of reserves. If the supply of reserves is high, then banks lend to each other at low rates, but if the level of reserves in the system drops, then banks lend to each other at a higher rate because the supply of reserves has fallen. So the banks ability to lend remains the same, it is the cost of lending that changes.