Fractional reserve banking is a system whereby banks only hold a fraction of their deposits in reserve, and lend out the rest. This system of banking has existed for centuries and is currently the global standard. Though many argue that there are some benefits to this system of banking, there are many inherent dangers and risks, and severe consequences of its failure.
Fractional Reserve banking carries a multitude of risks. The 5 primary risks and dangers of this system of banking are bank runs, credit & asset bubbles, systemic risk, moral hazards, and inflation. While there are various purported benefits to fractional reserve banking, this article is focusing on the inherent risks and dangers.
The Risk of Bank Runs
One of the primary dangers of fractional reserve banking is the risk of bank runs. If a large number of depositors lose confidence in a bank, or if a bank fails, oftentimes many people will rush to withdraw their deposits. Even if their bank isn’t the one failing, people will lose trust in the system and rush to collect their capital. Because banks, under the fractional reserve system, may not have enough reserves to meet the demands of all the simultaneous withdrawals, this can lead to a chain reaction of bank failures and an overall financial and systemic crisis.
The Federal Reserve, along with the Federal Deposit Insurance Corporation (FDIC) were created to help mitigate the risks of bank runs. The Federal Reserve, a private bank that does not operate under government oversight, can provide loans to banks to help their reserve requirements during a crisis, and the FDIC can provide deposit insurance to protect depositors’ funds in the event of a bank failure.
Credit & Asset Bubbles
When banks have access to large amounts of liquidity, as do banks that operate under the fractional reserve system, they might lend money to borrowers who may not be able to repay their loans. This can lead to a driving up of prices and create bubbles in assets such as real estate and stocks. When these bubbles burst, it can lead to significant financial instability.
Another inherent danger of fractional reserve banking is systemic risk. Systemic risk refers to the risk of a financial crisis spreading throughout the entire banking system. If one bank experiences a significant rise in loan defaults or other financial issues, that bank may not have enough reserves to cover its obligations, leading to a bank run — and bank runs can cause systemic failures, leading to a broader financial crisis that may eventually become a global financial crisis under the right set of circumstances.
The Moral Hazard Problem
Another inherent risk of this system of banking is what is the moral hazard problem. Knowing that their depositors’ funds are insured up to $250,000 by the government, banks may be tempted to take excessive risks when lending funds. This creates a moral hazard problem: banks take on more risk than they would if they were fully responsible for the consequences.
The 2008 global financial crisis is an apt example of the moral hazard problem. Banks took on excessive risks in the mortgage market believing that the governments would be able to bail them out should things take a downward trajectory. When the market indeed took a downward trajectory and crashed, it led to a systemic crisis that required a large and controversial government bailout — not to mention the significant amounts of social unrest.
The Inflationary Effect
Fractional reserve banking can also have an inflationary effect on the overall economy. When banks lens out funds, the money supply increases, which in turn can lead to inflation. If banks lend too quickly, they can cause an inflation spiral, where prices rise rapidly, and eventually even hyperinflation.
The FDIC insures deposits up to $250,000 per deposited, per FDIC insured bank, for each ownership category. Let’s break that down:
There are slightly over 5,000 FDIC insured banks in the United States, including both foreign and domestic owned institutions. This is the vast majority of US banks, as most banks in the US are required to have FDIC insurance to operate.
If a person has multiple accounts in different ownership categories, such as individual accounts, joint accounts, and retirement accounts, each account may be insured up to $250,000 separately.
This insurance limit was established in 2010 by the Dodd-Frank Wall Street Reform and Consumer Protection Act, following the financial crisis of 2008, and applies to most deposit accounts. These accounts include checking, savings, and money market accounts, as well as certificates of deposit accounts. According to the Federal Reserve’s 2022 Survey of Consumer Finances, roughly 92% of US households with bank accounts had balances of $250,000 or less, in 2021. As such, the overwhelming majority of bank accounts in the US fall under FDIC insurance coverage.
The Federal Reserve and the Federal Deposit Insurance Corporation were created to help mitigate the risk of bank runs. The Federal Reserve can provide loans to banks to help them meet their reserve requirements during a crisis, while the FDIC provides deposit insurance to protect depositors’ funds in the event of a bank failure. Because most US households with bank accounts hold balances of $250,000 or less, FDIC insurance can be a powerful mitigation tool against bank runs. However, these measures are not foolproof and may not be enough to prevent a crisis if too many banks fail simultaneously.
Where Does the FDIC Get the Money?
The FDIC acquires the money it needs to insure deposits from a variety of sources.
The FDIC has a good track record of successfully managing bank failures and patenting insured accounts. Unless there is a significant, widespread and historic systemic failure, the FDIC should potentially be able to cover the majority of insured accounts. This should ideally be a strong factor protecting against widespread bank runs. Even during times of notable economic stress, the FDIC should be able to maintain the stability of the overall banking system.
Institutions like the FDIC, ideally, make fractional reserve banking less risky for the everyday individual.
While fractional reserve banking is standard practice around the world, it wasn’t always so. In the future, it may or may not reign supreme — only time will tell. Although there are various purported benefits of this system of banking, it does nevertheless carry many significant and inherent risks. This is why institutions like the FDIC were created, so that those risks can be mitigated. While the measures put in place to mitigate the risks associated with fractional reserve banking, they are not foolproof, and the potential consequences of any type of banking crises can be severe. Bankers and regulators should always remain vigilant and ensure that banks are acting in a fiscally responsible and ethically moral manner.
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