Pretty everyone who has ever received a paycheck will have used a bank. However, many people are unaware of how the typical banking system actually works. In almost every country around the globe, central banks use a system called fractional reserve banking. So, what is fractional reserve banking and why is it important to understand it?
What is fractional reserve banking?
Fractional reserve banking is a banking system where banks keep a fraction of their deposits in cash and lend out the rest. The central bank sets a minimum reserve ratio, which is the percentage of deposits that banks must hold in reserve. For example, if the reserve ratio is 10%, this means that for every $100 a customer deposits, the bank can lend out $90.
Fractional reserve banking has been around for centuries, but it really came into prominence in the early 20th century after a series of banking crises. These crises were caused by banks lending out too much money and not having enough cash on hand to meet customer withdrawals.
To prevent future crises, central banks started to require banks to hold a minimum percentage of their deposits in reserve. This reserve ratio is what we now know as the fractional reserve.
How does fractional reserve banking work?
When customers deposit money into their account, the bank doesn’t just put that money into a big vault and wait for the customer to withdraw it. Instead, the bank uses some of that money to make loans to other people or businesses. This process of making loans and collecting interest on those loans is how banks make money.
For example, let’s say you deposit $100 into your bank account. The bank can then loan out $90 of that money to someone else. If the borrower pays back the loan with interest, the bank makes a profit.
The problem with fractional reserve banking is that it can create a lot of debt and inflation.
When the banks make loans, they are essentially creating new money. This new money doesn’t exist until the loan is made. So, when the banks loan out $90 of your $100 deposit, they are effectively creating $90 out of thin air.
This process of creating new money can lead to inflation because it increases the money supply in circulation without there being any new goods or services to match it.
In addition, fractional reserve banking can create a lot of debt because the loans that banks make must be repaid with interest. This means that there is more debt in the economy than there would be if the banks didn’t loan out money.
What are the pros and cons of fractional reserve banking?
There are both pros and cons to fractional reserve banking.
Some of the pros include:
- It allows banks to make profits by lending out money and collecting interest on those loans.
- It provides people with access to credit, which can help them start businesses or buy homes.
- It can help boost economic growth by increasing the amount of money available for lending and investment.
Some of the cons include:
- It can lead to inflation by increasing the money supply without there being any new goods or services to match it.
- It can create a lot of debt because the loans that banks make must be repaid with interest.
- It’s vulnerable to bank runs, which can occur when too many people try to withdraw their money at the same time.
Why is it important to understand fractional reserve banking?
Fractional reserve banking is important to understand because it’s the system that central banks use to manage the money supply. It’s also a key factor in inflation, economic growth, and debt levels.
If you want to get a better understanding of how the economy works, it’s important to understand fractional reserve banking and its role in the financial system.
In regards to trading cryptocurrencies, fractional reserve banking is also a key factor in understanding price discovery. The process of price discovery happens when buyers and sellers come together to trade an asset.
The price that they settle on is based on the supply and demand for that asset. However, the supply and demand for cryptocurrencies can be influenced by the amount of money that’s available to buy them.
If there’s more money available to buy a cryptocurrency, then the price will go up. This is because there are more buyers than there are sellers, so the buyers are willing to pay more for the cryptocurrency.
Conversely, if there’s less money available to buy a cryptocurrency, then the price will go down. This is because there are more sellers than there are buyers, so the sellers are willing to sell for less.
An alternative to fractional reserve banking
One alternative way to store your funds is to use a decentralized exchange, such as SokuSwap. A DEX is an exchange that allows users to buy and sell cryptocurrencies directly from each other.
DEX’s don’t require you to deposit your funds into an account with a central entity. Instead, you can keep your funds in your own personal wallet and trade directly with other users.
This decentralized approach has a number of advantages, including:
- Increased security: Since your funds are stored in your own personal wallet, you don’t have to worry about them being hacked or stolen.
- More privacy: DEX’s don’t require you to provide any personal information, so your transactions are more private.
- Greater control: You have full control over your funds and can decide when and where to trade them.
If you’re looking for a more secure and private way to store your funds, then a DEX may be the right choice for you.
Frequently asked questions
What does fractional reserve banking mean?
Fractional reserve banking is a system where banks keep a fraction of deposits in reserve and lend out the rest.
What is the reserve requirement?
The reserve requirement is the percentage of deposits that banks are required to keep in reserve.
How does fractional reserve banking work?
Fractional reserve banking works by allowing banks to loan out a fraction of deposits and keeping the rest in reserve. This can create new money and boost economic growth, but it can also lead to inflation and debt.
What is an advantage of fractional reserve banking?
One advantage of fractional reserve banking is that it can help boost economic growth by increasing the amount of money available for lending and investment.
What is a disadvantage of fractional reserve banking?
A disadvantage of fractional reserve banking is that it can lead to inflation by increasing the money supply without there being any new goods or services to match it.