If you need to borrow money, one of the first places you probably think of going is the bank. Everyone knows that banks offer credit cards and loans for everything from buying a home or a car to paying for your groceries.
However, you might wonder where that money comes from. The answer is rather simple: you and other depositors at the bank.
How the Banking Industry Works
The banking and financial industry is incredibly complex, employing millions worldwide and influencing almost every aspect of our daily lives in both massive and minute ways. Despite its immensity and complexity, if you distill it down to the basics, banking is pretty simple.
When someone opens a bank, they offer to hold people’s money and keep it safe. They’ll even pay interest on the money that people deposit, helping them grow their savings. As people deposit money into accounts at that bank, the bank’s balance grows.
The bank typically doesn’t just keep all that money inside a vault somewhere. It puts the money to use, lending it out to people who need it. The bank charges interest for the service of lending money.
Banks pay lower rates of interest to depositors than they charge borrowers, allowing them to earn a profit.
What is Fractional Reserve Banking?
There’s one obvious issue with this system. If you give your money to a bank, you expect to be able to withdraw it when you want to. After all, it’s your money, not the bank’s.
If the bank takes your money and lends it to someone else, what happens if you come to make a withdrawal before that borrower pays back their loan?
The entire system relies on the fact that it’s highly unlikely for every person who deposits money with a bank to want to withdraw all of their money at once. Instead, banks keep just a fraction of the money in their accounts on hand. This lets the bank handle withdrawal requests that come up while still being able to lend money to borrowers.
This is called fractional reserve banking. Banks only have to have a specific fraction of the money on deposit available for withdrawal. For example, if the required fraction is 10% and a bank has $100 million deposited, it can lend out $90 million and keep $10 million on hand to deal with customer withdrawals.
Primary vs. Secondary Reserves
Banks have primary and secondary reserves of cash.
Primary reserves are the more liquid of the two. All the cash a bank has, as well as highly liquid assets like deposits due from other banks and reserves housed in the Federal Reserve System, are included in primary reserves. A bank must maintain primary reserves sufficient to meet the fractional reserve requirements set by banking regulators.
Secondary reserves are also quite liquid but less so than primary reserves. Banks can use the money they have to purchase securities, like government bonds. These securities pay interest to the bank but are easy to sell and convert to cash as needed. Secondary reserves are held by banks that want additional liquidity on top of their legally required reserves.
The Money Multiplier Effect
Fractional reserve banking effectively allows banks to create money when they receive a deposit. This is called the money multiplier effect.
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Imagine a bank that has a 10% reserve requirement. It receives a deposit of $100,000. That means it needs to keep at least $10,000 on-hand to meet that reserve requirement. However, it’s free to do what pleases with the remaining $90,000.
If the bank originates a loan for $90,000, the borrower will receive those funds. However, the depositor’s account doesn’t see its balance fall to $10,000. It remains at $100,000. In effect, the bank created $90,000 out of thin air to lend to the borrower.
If that borrower goes and deposits their $90,000 loan in a different bank, that bank will keep $9,000 on hand and can make $81,000 in loans. This cycle can continue with banks using deposits to generate new money.
Banks don’t lend out the maximum amount allowed, but this shows how one deposit can lead to much more in loans and add a significant amount to the money supply.
Bank Runs
Fractional reserve banking is an old system that has weathered the test of time. The National Bank Act of 1863 required that banks maintain reserves on hand to protect depositors, so this system has been used in the US for at least a century and a half.
However, that doesn’t mean it’s infallible. What happens if people want to withdraw more money than a bank has on hand?
🏃♀️ A bank run occurs when depositors lose confidence in a bank and rush to withdraw money from their accounts. As more people pull money from their accounts and the bank’s reserves dwindle, it creates more panic and leads to more withdrawals. In some cases, a bank can run out of reserves and be unable to return the money that people deposited.
Bank runs have contributed to many economic catastrophes, including the Great Depression. Modern rules and regulations, as well as insurance from the Federal Deposit Insurance Corporation (FDIC), help protect depositors, even if a bank runs out of reserves, greatly limiting the frequency of and the damage caused by bank runs.
Pros and Cons of Fractional Reserve Banking
Fractional reserve banking has many benefits, giving banks the opportunity to encourage growth through lending. However, history has shown that the system is imperfect.
➕ Pros:
- Encourages economic growth. Lending helps to encourage economic growth by giving people access to more money than they’d otherwise have. Through loans, people can start new businesses or make expensive purchases, such as a home. It also puts money that would sit unused to use.
- Flexibility. Banks are free to lend as much or as little as they wish as long as they maintain the required reserves. Regulators and central bankers can also use those rules to influence the economy and try to avoid recessions.
- Better returns for savers. In theory, banks return some of their revenues to depositors in the form of interest on savings accounts and other deposit accounts. The more banks can earn from lending, the more savers will receive in interest.
- Lower interest rates. Interest is the price of money, and like the price of any other commodity, it is determined by supply and demand. More money available to lend means a higher supply and a lower price for lending.
➖ Cons:
- Risk. No matter how large the fraction is, if a bank does not have 100% of its deposits on reserve, there is a chance that it will receive more withdrawal requests than it can handle. This can lead to bank runs.
- Bad lending practices. If a bank makes bad loans and loses money, depositors could lose money, which can trigger recessions. The 2008 subprime mortgage crisis is one example of this.
- It creates money. Through the money-multiplier effect, banks can all but create money out of thin air. This grows the money supply which critics argue contributes to inflation.
Bank Regulations and How They Protect the Financial System
Fractional reserve banking has a proven history of success, albeit with many (often major) bumps along the way. With each bump, new regulations have been put in place both by the banks themselves and by external regulators.
These regulations are intended to reduce risk within the financial system and help protect depositors.
One basic regulation is the fractional reserve requirement. In the United States, the Federal Reserve sets the reserve requirement that banks must meet. Adjusting the reserve requirement can help adjust risk and is also a useful tool for managing the nation’s economy.
Another well-known regulation is the Dodd-Frank Act, which was put in place in 2010 after the onset of the 2008 housing crisis. This bill is wide-reaching but includes rules on how banks can invest and limit speculative trading to reduce risk. It also regulates the trading of risky derivatives.
A key entity for keeping depositors safe is the Federal Deposit Insurance Corporation. This group offers insurance to anyone who deposits money in a bank. The insurance covers up to $250,000 per account type, per depositor, at a bank. If a bank can’t return your money, the federal government will reimburse you for the losses, up to $250,000.
That high limit means that these days, relatively few people have to worry about losing money from a bank run or bank closure. The FDIC was created in the wake of the Great Depression and played a big role in stabilizing the banking industry.
How Federal Monetary Policy Influences Banks and Borrowing
Banking is constantly evolving thanks to our ever-changing economy. The Federal Reserve Board meets regularly to discuss the economy and its direction and to try to manage it to encourage stable growth.
The government’s monetary policy has a big impact on banks and their ability to lend money.
A key piece of monetary policy is managing the money supply. Adding money to the economy encourages growth and can fit recession, but it can also lead to inflation. Reducing the amount of money in the economy slows down growth and can help fight inflation but may cause a recession.
One tool for managing the money supply is the fractional reserve requirement. The Federal Reserve can lower the requirement if it wants banks to lend more money and boost the economy. In 2020 during the coronavirus pandemic, the fractional reserve requirement was dropped to 0% to help keep the economy active during the pandemic.
Another is the Federal Funds rate, the interest rate at which banks lend excess reserves to each other. This rate is a target rate set by the Federal Reserve. It uses various financial levers and activities to encourage banks to lend at the desired rate.
Higher Federal Funds rates drive interest rates for everything from loans to savings accounts up and discourage lending to consumers by giving banks more incentive to hold more cash in reserve. Lower Federal Funds rates discourage holding reserves and encourage loans to consumers.
Summary
Though the banking and financial system is highly complex, what it boils down to is banks taking money from depositors and lending it out to borrowers. The bank pays interest to depositors but charges higher rates to borrowers, taking the difference and using it to pay for its operations or letting it serve as profits.
