Saenredam – Het oude stadhuis te Amsterdam. Fractional-reserve banking is the current form of banking practiced in economics of money and banking mishkin pdf countries worldwide. Fractional-reserve banking predates the existence of governmental monetary authorities and originated many centuries ago in bankers’ realization that generally not all depositors demand payment at the same time.
Thus fractional-reserve banking was born. In order to mitigate the impact of bank failures and financial crises, central banks were also granted the authority to centralize banks’ storage of precious metal reserves, thereby facilitating transfer of gold in the event of bank runs, to regulate commercial banks, impose reserve requirements, and to act as lender-of-last-resort if any bank faced a bank run. The emergence of central banks reduced the risk of bank runs which is inherent in fractional-reserve banking, and it allowed the practice to continue as it does today. In other words, the funds deposited are no longer the property of the customer. Each bank is legally authorized to issue credit up to a specified multiple of its reserves, so reserves available to satisfy payment of deposit liabilities are less than the total amount which the bank is obligated to pay in satisfaction of demand deposits.
Fractional-reserve banking ordinarily functions smoothly. Relatively few depositors demand payment at any given time, and banks maintain a buffer of reserves to cover depositors’ cash withdrawals and other demands for funds. If creditors are afraid that the bank is running out of reserves or is insolvent, they have an incentive to redeem their deposits as soon as possible before other depositors access the remaining reserves. Thus the fear of a bank run can actually precipitate the crisis. Fractional-reserve banking allows banks to create credit in the form of bank deposits, which represent immediate liquidity to depositors. The process of fractional-reserve banking expands the money supply of the economy but also increases the risk that a bank cannot meet its depositor withdrawals. Modern central banking allows banks to practice fractional-reserve banking with inter-bank business transactions with a reduced risk of bankruptcy.
Simultaneously, an equal amount of new commercial bank money is created in the form of bank deposits. At least one textbook states that when a loan is made by the commercial bank, the bank is keeping only a fraction of central bank money as reserves and the money supply expands by the size of the loan. This process is called “deposit multiplication”. However, as explained below, bank loans are only rarely made in this way.
The proceeds of most bank loans are not in the form of currency. Deposits created in this way are sometimes called derivative deposits and are part of the process of creation of money by commercial banks. Issuing loan proceeds in the form of paper currency and current coins is considered to be a weakness in internal control. 100 through fractional-reserve banking with varying reserve requirements. Each curve approaches a limit.