Fractional Reserve Banking

D

In a fractional reserve system, a bank can loan out almost all of the deposits it receives, maintaining only a small part as reserves to meet regular withdrawals and as a provision for loan defaults.

Fractional Reserve Banking refers to the banking system where banks are required to hold only a fraction of the deposits they receive as reserves, while the remaining portion can be used for lending or other investment activities. The correct answer to the question is option D: "The banking system where banks hold less than 100% reserves against deposits."

In a fractional reserve banking system, when individuals and businesses deposit money into banks, the banks are not required to keep the entire amount of the deposit as cash in their vaults. Instead, they are only obligated to hold a fraction of the deposited amount as reserves. The reserve requirement is typically determined by the central bank or regulatory authorities of a country.

The reserve requirement serves as a measure to maintain the stability of the banking system and ensure that banks have enough liquidity to meet withdrawal demands from depositors. The fraction of reserves held by banks is often set as a percentage of their total deposits. For example, if the reserve requirement is 10% and a bank receives a deposit of $1,000, it is required to hold $100 (10% of $1,000) as reserves and can use the remaining $900 for lending or other activities.

The practice of fractional reserve banking allows banks to create money through the lending process. When banks make loans, they create new deposits in the accounts of borrowers. For example, if a bank lends $900 to a borrower, the borrower will have a new deposit of $900 in their account, while the bank still holds the original $1,000 deposit as reserves. This process effectively increases the money supply within the economy.

Fractional reserve banking also introduces the concept of the money multiplier. The money multiplier refers to the potential expansion of the money supply that can result from the initial deposit and subsequent lending. The actual expansion of the money supply depends on the reserve requirement set by the central bank. A lower reserve requirement allows for a higher money multiplier and a greater expansion of the money supply.

It is important to note that while fractional reserve banking allows for the creation of money and promotes economic growth through lending and investment, it also exposes the banking system to certain risks. If there is a sudden loss of confidence in the banking system or a significant number of depositors try to withdraw their funds simultaneously, banks may face liquidity problems since they do not hold 100% of the deposited funds. This situation can lead to bank runs and financial instability, which is why central banks play a crucial role in regulating and overseeing the fractional reserve banking system.

In summary, fractional reserve banking refers to the banking system where banks hold less than 100% reserves against deposits. It allows banks to lend and invest a portion of the deposits they receive, which contributes to the expansion of the money supply and economic growth. However, it also exposes the banking system to risks related to liquidity and financial stability.