Fractional Reserve Banking
Now that we have understood the concept of warehouse banking lets move on to an example of fractional reserve banking and how fractional reserve banking impacts the money supply in an economy.
Fractional Reserve Banking Innovation
Continuing from the warehouse banking example the payments system in Metrocity has evolved to exchanging ownership of deposits rather than cash. Now some of the financial wizards in Metrocity notice that the deposits in banks vault are barely touched and the cost of payments has greatly reduced. Another interesting idea is born. Instead of depositors lending money and taking on the credit risk, the risk of the borrower defaulting, what if the banks started lending.
Banks do not have actual cash deposits of their own account but could create deposits on behalf of the borrower and loan those deposits to the borrower. The borrower would have deposits in the bank without actually having any cash deposits with the bank.
Lets assume Yuri is now in need of money and approaches Megabank credit department for a $5 million loan. If the credit department approves Megabank creates a $5 million deposit account for Yuri, which he can draw upon. In exchange Yuri signs an loan document that is essentially an IOU. This new innovation changes the entire banking system of Metrocity.
When Yuri draws on his deposits through checks, Megabank loses cash to other banks through Centralbank. The cash doesn’t belong to Megabank but to the real depositors who are compensated by Megabank with deposit interest or free facilities such as free checking accounts.
Fractional Reserve Banking – Cash in Vault
Lets see the implications of this banking innovation on Metrocityâ€™s economy. Prior to the lending innovation, deposits in Megabank were one to one correspondence with cash in the vault. With the creation of deposits through the lending facility the one to one correspondence is no longer valid. The depositors claim is now on the general assets of the bank instead of the cash in vault. The cash in vault now becomes a general reserve. This general reserve, which is now but a fraction of the total deposit of a bank, now only helps ensure that a promise to pay depositors can be met.
This new type of banking is called fractional-reserve banking and has huge implications on the quantity of money in Metrocity.
Fractional Reserve Banking – Impact on Quantity of Money
Lets assume the total quantity of money in Metrocity before the innovation of banking was a $1000 million. With the advent of warehouse banking the total quantity of money in the economy still remains intact. The deposits made in the warehouse banks are cash. Payments are made by transferring ownership of deposits. There is a one to one correspondence between cash and deposits in the warehouse banking economy. Since deposits is the new way of making payments we need to include deposits in the definition of Money in Metrocity.
Money is now cash or currency and deposits. However for each $1 deposited $1 cash is retired from the system to the bankâ€™s vault. The money locked in the bankâ€™s vault is not for public use, however the deposits are and therefore the quantity of money in the economy is the quantity of money held by the public not including money in the vaults. So if the total deposits in Metrocity is say $500 million due to the one to one correspondence there is also $500 in vaults.
The total quantity of money is = total currency ($1000) – $ in bankâ€™s vaults ($500) + bank deposits ($500) = $1000
We see here that warehouse banks do not change the quantity of money in the economy.
However with the lending innovation created by the wizards of Megabank the quantity of money in Metrocity is altered and the one to one correspondence is no longer valid.
When Yuri is granted a $5 million loan by Megabank, Megabank creates a deposit without an addition to cash in the bank vaults. The total quantity of money in Metrocity now becomes
The total quantity of money is = total currency ($1000) – $ in bankâ€™s vaults ($500) + bank deposits ($505) = $1005
This is an important concept in understanding how banking assets can change the quantity of money in an economy.
We can extend the example to understand the concept of banking reserves and how changes in reserves affect the quantity of money and in turn interest rates. We also understand the relationship between interest rate and exchange rates, sources of demand and supply for loans and foreign exchange and the effects of change of the quantity of money on interest and exchange rates in the flow of funds or Financial Accounts of the United States.