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Fractional-reserve banking refers to the maintenance of total reserves that are a fraction of the bank's total demand liabilities. Reserves means legal tender assets that can directly discharge the bank's liabilities, however under central banking systems it will also include balances with the central bank. Demand liabilities includes banknotes and demand deposits issued by the bank. Fraction means a fraction less than 1. The alternative to fractional reserve banking is full-reserve banking.

Contents 1 Illustration of a Fractional Reserve Bank 2 Avoiding Confusion with Capital Ratio etc. 3 Liquidity Management For a Fractional Reserve Bank 4 Real Example of a Fractional Reserve Bank Balance Sheet and Financial Ratios 4.1 Other Financial ratios 4.2 How the Example Bank Manages its Liquidity 5 Convertibility 5.1 Increased money supply and inflation 6 History 7 Government regulation 8 Influence of central banks 9 Criticisms 9.1 Business Cycle 9.2 Risk 9.3 Incompatible with a gold standard 9.4 Inadequate government regulation 10 See also 11 References 12 External links 12.1 Libertarian viewpoint

Example 1: Example Bank Limited Balance Sheet as at 30 September 2007
Assets		Liabilities
Specie	300	Banknotes issued	1000
Total Reserves	300	Demand Deposits	9000
Banknotes issued by other banks	100	Total Demand Liabilities	10000
Demand deposits with other banks	300	Term Deposits	6000
Marketable Debt Securities	2000	Bonds issued	2500
Total Liquid Assets	2700	Total Liabilities	18500
Net loans and advances	17000	Equity	1500
Other Assets	300
Total Assets	20000	Total Liabilities plus Equity	20000

In this case the reserve ratio is worked out as Total Reserves/Total Demand Liabilities, i.e. 300/10000, which is 3%. Because the reserve ratio is less than 100%, the bank is said to be engaging in fractional reserve banking.

It is important not to confuse a bank's reserve ratio with its capital ratio, or other financial ratios. The example above shows equity (capital) of 1500 and total assets of 20000, to give a capital ratio of 7.5%. (Note that this figure is not risk weighted.)

It is also important to note that the term 'reserves' in the reserve ratio generally does not include all liquid assets, for example the above example shows a total of 2700 in liquid assets, including 2400 in assets that the bank could relatively easily and reliably redeem or sell to replenish its stock of reserves. Thus while the bank's reserve ratio is 3% its liquid assets to demand debt ratio is 27%.

To avoid defaulting on its obligations, the bank must maintain a reserve ratio greater than zero. In practice this means that the bank sets a reserve ratio target and responds when the actual ratio falls below the target by:

1. Selling or redeeming other assets,
2. Restricting investment in new loans,
3. Borrowing funds (whether repayable on demand or at a fixed maturity), or
4. issuing additional capital.

Because different funding options have different costs, and differ in reliability, banks maintain a stock of low cost and reliable sources of liquidity such as:

1. Demand deposits with other banks
2. High quality marketable debt securities
3. Committed lines of credit with other banks

As with reserves, other sources of liquidity are managed with targets.

The ability of the bank to borrow money reliably and economically is crucial, which is why confidence in the bank's creditworthiness is important to its liquidity. This means that the bank needs to maintain adequate capitalisation and to effectively control its exposures to risk in order to continue its operations. If creditors doubt the bank's assets are worth more than its liabilities, all demand creditors have an incentive to demand payment immediately, a situation known as a run on the bank.

Contemporary bank management methods for liquidity are based on maturity analysis of all the bank's assets and liabilities (off balance sheet exposures may also be included). Assets and liabilities are put into residual contractual maturity buckets such as 'on demand', 'less than 1 month', '2-3 months' etc. These residual contractual maturities may be adjusted to to account for expected counter party behaviour such as early loan repayments due to borrowers refinancing and expected renewals of term deposits to give forecast cash flows. This analysis highlights any large future net outflows of cash and enables the bank to respond before they occur. Scenario analysis may also be conducted, depicting scenarios including stress scenarios such as a bank-specific crisis.

An example of fractional reserve banking, and the calculation of the reserve ratio is shown in the balance sheet below:

Example 2: ANZ National Bank Limited Balance Sheet as at 30 September 2007
Assets	NZ$m	Liabilities	NZ$m
Cash	201	Demand Deposits	25482
Balance with Central Bank	2809	Term Deposits and other borrowings	35231
Other Liquid Assets	1797	Due to Other Financial Institutions	3170
Due from other Financial Institutions	3563	Derivative financial instruments	4924
Trading Securities	1887	Payables and other liabilities	1351
Derivative financial instruments	4771	Provisions	165
Available for sale assets	48	Bonds and Notes	14607
Net loans and advances	87878	Related Party Funding	2775
Shares in controlled entities	206	[subordinated] Loan Capital	2062
Current Tax Assets	112	Total Liabilities	99084
Other assets	1045	Share Capital	5943
Deferred Tax Assets	11	[revaluation] Reserves	83
Premises and Equipment	232	Retained profits	2667
Goodwill and other intangibles	3297	Total Equity	8703
Total Assets	107787	Total Liabilities plus Net Worth	107787

In this example the (legal tender) cash held by the bank is $201m and the demand liabilities of the bank are $25482m, for a (legal tender) cash reserve ratio of 0.79%.

The key financial ratio used to analyse fractional-reserve banks is the cash reserve ratio, which is the ratio of cash reserves to demand deposits and notes. However, other important financial ratios are also used to analyse the bank's liquidity, financial strength, profitability etc.

For example the ANZ National Bank Limited balance sheet above gives the following financial ratios:

1. The (legal tender) cash reserve ratio is $201m/$25482m, i.e. 0.79%.
2. The central bank notes/balances reserve ratio is $3010m/$25482m, i.e. 11.81%.
3. The liquid assets reserve ratio is ($201m+$2809m+$1797m)/$25482m, i.e. 18.86%.
4. The equity capital ratio is $8703m/107787m, i.e. 8.07%.
5. The tangible equity ratio is ($8703m-$3227m)/10787m, i.e. 5.08%
6. The total capital ratio is ($8703m+$2062m)/$10787m, i.e. 9.98%.

Clearly, then, it is very important how the term 'reserves' is defined for calculating the reserve ratio, and different definitions give different results. Other important financial ratios may require analysis of disclosures in other parts of the bank's financial statements. In particular, for liquidity risk, disclosures are incorporated into a note to the financial statements that provides maturity analysis of the bank's assets and liabilities and an explanation of how the bank manages its liquidity.

The ANZ National Bank Limited explains its methods as:

Liquidity risk is the risk that the Banking Group will encounter difficulties in meeting commitments associated with its financial liabilities, e.g. overnight deposits, current accounts, and maturing deposits; and future commitments e.g. loan draw-downs and guarantees. The Banking Group manages its exposure to liquidity risk by maintaining sufficient liquid funds to meet its commitments based on historical and forecast cash flow requirements.

The following maturity analysis of assets and liabilities has been prepared on the basis of the remaining period to contractual maturity as at the balance date. The majority of longer term loans and advances are housing loans, which are likely to be repaid earlier than their contractual terms. Deposits include substantial customer deposits that are repayable on demand. However, historical experience has shown such balances provide a stable source of long term funding for the Banking Group. When managing liquidity risks, the Banking Group adjusts this contractual profile for expected customer behaviour.

Example 2: ANZ National Bank Limited Maturity Analysis of Assets and Liabilities as at 30 September 2007
	Total carrying value	Less than 3 months	3-12 months	1-5 years	Beyond 5 years	No Specified Maturity
Assets
Liquid Assets	4807	4807
Due from other financial institutions	3563	2650	440	187	286
Derivative Financial Instruments	4711					4711
Assets available for sale	48	33	1	13		1
Net loans and advances	87878	9276	9906	24142	44905
Other Assets	4903	970	179			3754
Total Assets	107787	18394	10922	25013	45343	8115
Liabilities
Due to other financial institutions	3170	2356	405	32	377
Deposits and other borrowings	70030	53059	14726	2245
Derivative financial instruments	4932					4932
Other liabilities	1516	1315	96	32	60	13
Bonds and notes	14607	672	4341	9594
Related party funding	2275	2275
Loan capital	2062		100	1653	309
Total liabilities	99084	60177	19668	13556	746	4937
Net liquidity gap	8703	(41783)	(8746)	11457	44597	3178
Net liquidity gap - cumulative	8703	(41783)	(50529)	(39072)	5525	8703

Typically, privately-issued checking account dollars are convertible into paper dollars on demand. But paper dollars issued by the central bank are no longer convertible into silver (or gold, as the case may be). The Federal Reserve Note is thus physically inconvertible, although it remains financially convertible, in the sense that the central bank stands ready to use its bonds to buy paper dollars issued by the commercial banking system. For example, during the Christmas shopping season, when the demand for cash is high, the Federal Reserve will normally swap about 10 billion paper dollars for $10 billion in bonds from the commercial banking system.^{[citation needed]} After the shopping season ends, the Federal Reserve will swap $10 billion in bonds for 10 billion paper dollars from the commercial banking system, thus soaking up the now superfluous paper dollars.

Main articles: Money supply and Inflation

Since fractional reserve banking involves the issue of money, the link to inflation has been the subject of debates. According to the quantity theory of money, the expansion of the money supply leads to "more money chasing the same amount of goods" and thus to inflation. Some monetarists believe that the exchange rate or purchasing power of the monetary unit is governed by the quantity of money, including demand deposits and notes, and therefore view fractional reserve banking as a cause of inflation. In fact quantity theorists often call the issue of bank-money 'inflation' and consider a falling exchange rate merely a symptom of inflation.^{[citation needed]} Most schools of economics recognize the link between money supply and inflation; many economists, however, consider the issue of money through the banking system as a mechanism of monetary transmission, which a central bank can influence indirectly by raising or lowering interest rates (although banking regulations may also be adjusted to influence the money supply, depending on the circumstances).

Quantity theorists may either be hostile to fractional reserve banking or supportive of minimum reserve ratios and other government controls on the quantity of money created by commercial banks. The process with which commercial banks practice fractional-reserve banking is explained at deposit creation multiplier.

This article appears to contradict the article History of banking. Please see discussion on the linked talk page.

At one time, people deposited gold coins and silver coins at goldsmiths for safe keeping, receiving in turn a note for their deposit. Once these notes became a trusted medium of exchange an early form of paper money was born, in the form of gold certificates and silver certificates.

As the notes were used directly in trade, the goldsmiths noted that people would never redeem all their notes at the same time, and saw the opportunity to issue new bank notes in the form of interest paying loans. These generated income—a process that altered their role from passive guardians of bullion charging fees for safe storage, to interest-paying and earning banks. Fractional-reserve banking was born. When creditors (the owners of the notes) lost faith in the ability of the bank to exchange their notes back into coins, many would try to redeem their notes at the same time. This was called a bank run and many early banks either went into insolvency or refused to pay up.

Banking has been subject to generally a greater extent of government regulation and controls than other forms of business, and banking law has in many countries been the subject of extensive political debate.

Government controls and bank regulations related to fractional-reserve banking have generally been to impose restrictive requirements on note issue and deposit taking on the one hand, and to provide relief from bankruptcy and creditor claims, and/or protect creditors with government funds, when banks defaulted on the other hand. Such measures have included:

1. Minimum required reserve ratios (RRRs)
2. Minimum capital ratios
3. Government bond deposit requirements for note issue
4. 100% Marginal Reserve requirements for note issue, such as the Peels Act 1844 (UK)
5. Sanction on bank defaults and protection from creditors for many months or even years, and
6. Central bank support for distressed banks, and government guarantee funds for notes and deposits, both to counter-act bank runs and to protect bank creditors.

Central banks are government owned or sponsored banks that issue banknotes and typically receive special privileges in the form of exemption from restrictions or taxes on note issue, or whose banknotes are made legal tender by government fiat (hence the term fiat currency).

Central banks also operate as fractional-reserve banks, and the reserve ratio policies of the central bank influence specie flows and credit conditions, making the control of fractional-reserve banking a political issue, with financial and economic impacts. Also involved with reserve ratios is the interest rate, because the primary method of attracting cash reserves from within a country and from abroad into the central bank, or stemming their outflow, is to offer higher interest rates on deposits (central banks take deposits as well as issue banknotes).

Some political libertarians and some supporters of a gold standard use the term fractional-reserve banking in reference to fractional-reserve banking by central banks in particular, where the nation's central bank holds fractional reserves of gold bullion, specie (gold coin) or other reserves (such as foreign currency). This occurred before the adoption of irredeemable fiat money in most developed countries in 1971 with the collapse of the Bretton Woods system, when the US government defaulted on its gold payment obligations under the agreement. This usage is superficially similar to the standard usage in economics, in that the ability of a country to redeem only part of its currency in gold can be seen as analogous to the ability of a bank to redeem only part of its deposits in cash, but referring to partly-reserved currencies as a form of fractional-reserve banking may create more confusion than it alleviates. Mainstream economists do not generally make this analogy.

This section may contain original research or unverified claims. Please help Wikipedia by adding references. See the talk page for details.

The examples and perspective in this article or section may not represent a worldwide view of the subject. Please improve this article or discuss the issue on the talk page.

Although fractional-reserve banking is near universal, it is not without criticism. The primary criticisms relate to the financial risk note holders and depositors bear, and the impact bank notes and demand deposits have on the stock of money, and potentially its value (that is, the effect on inflation and the exchange rate). The proposed alternative to fractional reserve banking is full-reserve banking.

Main articles: Austrian School and Business_cycle#Austrian_School

Fractional Reserve Banking allows an increase in the supply of currency available to make loans to purchase investment capital, without increasing the quantity of investment capital or real savings. The quantity of loans will be higher than the actual supply of saved resources available for investment. Investors will assume that the quantity of loans available represents real savings. This misinformation leads investors to misallocate capital, borrowing and investing too much in long-term projects for which there is insufficient demand and real savings. As investors spend borrowed currency, segments of the economy will boom. Later investors will find the prices of their outputs falling and their costs rising, leading to the failure of new projects and a bust.

Main article: Full-reserve banking

Fractional-reserve banking allows for the possibility of a bank run in which the demand depositors and note holders collectively attempt to withdraw more money than the bank has in reserves, causing the bank to default. The bank would then be liquidated and the creditors of the bank would suffer a loss if the proceeds from the bank's assets were insufficient to pay its liabilities. Since liquidation may require selling assets quickly, and potentially in large enough quantities to affect the price of those assets, an otherwise solvent bank (whose assets are worth more than its liabilities) may be made insolvent by a bank run. This problem potentially exists for any corporation with debt or liabilities, but is more critical for banks as they rely upon public deposits (which may be redeemable upon demand).

Although an initial analysis of a bank run and default points to the bank's inability to liquidate or sell assets (i.e. because the fraction of assets not held in the form of liquid reserves are held in less liquid investments such as loans), a more full analysis indicates that depositors will cause a bank run only when they have a genuine fear of loss of capital, and that banks with a strong risk adjusted capital ratio should be able to liquidate assets and obtain other sources of finance to avoid default. For this reason fractional-reserve banks have every reason to maintain their liquidity, even at the cost of selling assets at heavy discounts and obtaining finance at high cost, during a bank run (to avoid a total loss for the contributors of the bank's capital, the shareholders).

Responses to the problem of financial risk described above include:

1. Opponents of fractional reserve banking who insist that notes and demand deposits be 100% reserved;
2. Proponents of prudential regulation, such as minimum capital ratios, minimum reserve ratios, central bank or other regulatory supervision, and compulsory note and deposit insurance, (see Controls on Fractional-Reserve Banking below);
3. Proponents of free banking, who believe that banking should be open to free entry and competition, and that the self-interest of debtors, creditors and shareholders should result in effective risk management; and,
4. Withdrawal restrictions: some bank accounts may place a limit on daily cash withdrawals and may require a notice period for very large withdrawals. Banking laws in some countries may allow restrictions to be placed on withdrawals under certain circumstances, although these restrictions may rarely, if ever, be used.

Main articles: Gold standard, Seigniorage, and Austrian School

Many critics of irredeemable fiat currency see fractional-reserve banking as incompatible with a return of the gold standard, despite the fact that most countries that used a gold standard in the twentieth century had commercial fractional reserve banking. These critics claim that fractional-reserve banking leading to exhaustion of reserves, prompting governments to make the notes of government-favored banks legal tender, even though the issuer is in default. If such defaulted bank notes are made legal tender by government fiat, as they trade at a discount to their face value in terms of gold coin, will be a cheaper way to discharge debts, driving out gold coin. In countries where commercial banks do not issue bank notes, this issue does not exist.

However, other critics of irredeemable fiat currency, from the free banking school, support fractional-reserve banking, and view the threat to the gold standard as originating from central banking and government controls on the formation and winding-up of banks and the business of banking.

Critics of current bank regulations argue that:

1. Minimum reserve ratios put reserves beyond reach in a time of need
2. Minimum capital ratios are poor regulators of financial risk, as they ignore other portfolio risk drivers such as scale and diversification and come at a heavy compliance cost
3. Government bond deposit schemes distort government bond prices, bank portfolios and finance methods, and create inflexibility
4. 100% marginal reserve requirements can be met even if the bank has no reserves
5. Protecting insolvent banks from their creditors creates moral hazard, and increases the losses bad banks make, and is inequitable, and
6. Central bank support and government protection of creditors creates moral hazard and socializes credit risk.

• Bimetallism
• Bretton Woods system
• Credit money
• Debt-based monetary system
• Digital gold currency
• Fiat currency
• Full-reserve banking
• Gold standard
• Islamic banking
• Money supply
• Money creation
• Monetary reform
• Seignorage
• Usury
• List of economics topics
• List of finance topics
• List of business ethics, political economy, and philosophy of business topics

• Huerta de Soto, J. (2006), Money, Bank Credit and Economic Cycles, Ludwig von Mises Institute
• Meigs, A.J. (1962), Free reserves and the money supply, Chicago, University of Chicago, 1962.
• Crick, W.F. (1927), The genesis of bank deposits, Economica, vol 7, 1927, pp 191-202.
• Philips, C.A. (1921), Bank Credit, New York, Macmillan, chapters 1-4, 1921,
• Thomson, P. (1956), Variations on a theme by Philips, American Economic Review vol 46, December 1956, pp. 965-970.
• Parliament of Tasmania, Monetary System, Report of Select Committee, With Minutes of Proceedings, 1935.
• John F. Kennedy vs The Federal Reserve
• More John F. Kennedy vs The Federal Reserve

• Rothbard, M. N. (1983) The Mystery of Banking, Richardson & Snyder, 1983, pp 87-110

• Narrow banking

• Money upside down

• Seignorage and inflation tax

• Fractional reserve banking and usury

These links discuss "fractional-reserve banking" from the Libertarian perspective. Economic libertarianism is critical of the practice and proposes alternative systems.

• Fractional-reserve banking Murray N. Rothbard uses the term "fractional-reserve banking" in reference to both commercial and central bank practices. He characterizes the customary modern-day practices with terms such as counterfeit, swindle, and "creating money out of thin air," and asserts that "the general public, not inducted into the mysteries of banking, still persists in thinking that their money remains 'in the bank.'"

• Money, Banking, and The Federal Reserve, afs video stream from The Ludwig von Mises Institute. Good presentation of the Misesean case against the Federal Reserve System.

• The Wikipedia entry Business Cycle: Austrian School gives an overview of the Austrian School's views on the relationship between Fractional Reserve Banking, Fiat Money, Credit Policies and the Business Cycle.

• Fractional Reserve Banking as Economic Parasitism An extensively researched, free, 67-page scientific paper with a 69 item bibliography with notes/comments on most major references (c. 2002).

• Wikipedia entry The Money Masters summarizes a widely seen movie documentary on the history of central banking, monetary policy, the "bond system", the Federal Reserve System, and fractional-reserve banking in the United States.

• The Libertarian Case Against Fractional-Reserve Banking is a critical analysis of Rothbard's views by Gene Callahan, who finds them unconvincing, and asserts that banking practices are compatible with Libertarianism, or could be made so with only minor alterations. He discusses at length (but inconclusively) the question of what depositors actually believe, which he sees as relevant to the charge that fractional-reserve banking is fraudulent or deceptive.