Fractional reserve banking is a banking system used around the world, and is currency the global banking standard. Under fractional reserve banking, banks hold in reserve only a fraction of the total deposits, while the remaining are lent out to borrowers. While this system has been widely used for centuries, it is not without its risks. Here are 5 of the biggest risks associated with fractional reserve banking.
One of the most significant risks associated with fractional reserve banking is the possibility of bank runs. Bank runs occur when a significant percentage of depositors lose confidence in their bank, or in the financial system at large, and withdraw their capital en masse. Because banks only hold a fraction of the total deposits, they are unable to meet the demand and inevitably fail. Depending on how large the bank is, a bank failure can cause catastrophic effects on the financial system, and can trigger bank contagion.
Fractional reserve banking allows banks to create credit by lending out more capital than they hold in reserve. While this can stimulate economic growth, it comes at the risk of credit expansion. Credit expansion is when banks lend out more than the overall economy can sustain, leading to inflation and asset bubbles.
Allowing banks to lend out more money than they actually hold in reserves creates systemic risk. The failure of one bank — especially if it is a large institution — can lead to a chain reaction that collapses the entire financial system. In a nutshell, this is what occurred during the 2008 financial crisis.
Moral hazards occur when banks take on too much risk, knowing that the government will bail them out if they fail. This incentivizes risky lending practices and an overall lack of accountability.
Under fractional reserve banking, banks may not have enough liquid assets to meet their obligations in the short term. This creates a significant liquidity risk and can lead to banks selling off assets at a discount, and potentially trigger a widespread financial crisis.
Bank runs, credit expansion, systemic risk, moral hazard, and liquidity risk are all potential dangers of fractional reserve banking. Because the global financial system is essentially entirely fractional reserve, this carries significant risk worldwide. By maintaining adequate reserves, limiting risky lending practices, and ensuring proper regulation, banks can help ensure the stability of our financial system.
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