Fractional-reserve banking

Fractional-reserve banking, the most common form of banking practiced by commercial banks worldwide, involves banks accepting deposits from customers and making loans to borrowers while holding in reserve an amount equal to only a fraction of the bank's deposit liabilities. Bank reserves are held as cash in the bank or as balances in the bank's account at a central bank. The country's central bank determines the minimum amount that banks must hold in liquid assets, called the "reserve requirement" or "reserve ratio". Banks usually hold more than this minimum amount, keeping excess reserves. Bank deposits are usually of a relatively short-term duration while loans made by banks tend to be longer-term – this requires banks to hold reserves to provide liquidity when depositors withdraw their money. Banks, working on the expectation that only a proportion (or 'fraction') of depositors will seek to withdraw funds at the same time, keep only a fraction of their liabilities as reserves. Thus they can experience an unexpected bank run when depositors wish to withdraw more funds than the reserves held by the bank. In that event, the bank experiencing the liquidity shortfall may borrow from other banks in the interbank lending market; or (if there is a general lack of liquidity among the banks) the country's central bank may act as lender of last resort to provide banks with funds to cover this short-term shortfall.Because banks hold reserves in amounts that are less than the amounts of their deposit liabilities, and because the deposit liabilities are considered money in their own right (see commercial bank money), fractional-reserve banking permits the money supply to grow beyond the amount of the underlying base money originally created by the central bank. In most countries, the central bank (or other monetary-policy authority) regulates bank-credit creation, imposing reserve requirements and capital adequacy ratios. This helps ensure that banks remain solvent and have enough funds to meet demand for withdrawals, and can be used to limit the process of money creation in the banking system. However, rather than directly controlling the money supply, central banks usually pursue an interest-rate target to control bank issuance of credit and the rate of inflation.


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