Fractional-reserve banking

Fractional-reserve banking is the system of banking operating in almost all countries worldwide,[1][2] under which banks that take deposits from the public are required to hold a proportion of their deposit liabilities in liquid assets as a reserve, and are at liberty to lend the remainder to borrowers.[3] Bank reserves are held as cash in the bank or as balances in the bank's account at the 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". Most commercial banks hold more than this minimum amount as excess reserves.

Bank deposits are usually of a relatively short-term duration, and may be "at call", while loans made by banks tend to be longer-term,[4] resulting in a risk that customers may at any time collectively wish to withdraw cash out of their accounts in excess of the bank reserves. The reserves only provide liquidity to cover withdrawals within the normal pattern. Banks and the central bank expect that in normal circumstances only a proportion of deposits will be withdrawn at the same time, and that the reserves will be sufficient to meet the demand for cash. However, banks routinely find themselves in a shortfall situation or may 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 routinely borrow short-term funds in the interbank lending market from banks with a surplus. In exceptional situations, the central bank may provide funds to cover the short-term shortfall as lender of last resort.[3][5]

Because banks hold in reserve less than the amount 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.[3][5] 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.[5] 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.[6]

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