Pros:

• Increased Liquidity: When banks are allowed to lend out more money than they hold in reserve, this increases the amount of available credit in the overall economy. This can stimulate economic growth and facilitate investment.

• Increased Profitability: By lending out more than they have in deposits, banks can earn interest on the additional funds, increasing their profitability.

• Facilitates Payments: Fractional reserve banking allows for the issuance of checks and other payment instruments, making transactions more convenient and efficient.

Cons:

• Increased Risk: Under this system of banking, there is a significant risk of bank runs, where depositors withdraw funds en masse due to a loss of confidence in the bank’s ability to repay them, leading to a potential liquidity crisis or bank failure.

• Credit Expansion: 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.

• Amplifies Economic Cycles: By providing credit during economic booms, fractional reserve banking can exacerbate economic cycles. This can lead to inflation, and reduce credit during downturns, which can exacerbate economic contraction.

• Moral Hazard & Mismanagement: Fractional reserve banking can be mismanaged by banks, leading to over-lending, excessive risk-taking, and misallocation of resources, which can lead to financial instability and crises. Many argue that this system of banking incentivized risk taking, since banks may feel that governments will reliably bail them out.

• Potentially Inflationary: Fractional reserve banking can be inflationary as this system increases the money supply, leading to an increase in prices and reducing the value of currency.

• Systemic Risk: 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.

Conclusion

Fractional reserve banking has been around for centuries, and has both advantages and disadvantages. This system of banking tends to increase liquidity profitability and can facilitate payments, but carries with it numerous risks. Regulation and supervision are necessary to mitigate the risks of fractional reserve banking and ensure that banks operate transparently and responsibly.