The fractional reserve system is a banking system that allows commercial banks to lend out part of their customers' deposits and make a profit. In this case, only a small part of the customer's deposits can be Cash withdrawals are stored in the form of cash. In effect, this system is a way for banks to use a certain percentage of customers' bank deposits to create money.

 In other words, banks only need to deposit a small part of the funds in bank vaults or central bank accounts, while most of the remaining funds can be used for lending or investment. When a bank issues a loan, both the bank and the borrower regard this portion of the funds as an asset, and the original amount is doubled in economic terms. These funds are then reused, reinvested or lent again multiple times, creating a multiplier effect, and this is how fractional reserve banking is used to create "new money."

Loans and debt are part of a fractional-reserve banking system and typically require the central bank to put new currency into circulation so that commercial banks can provide cash withdrawals. Most central banks also act as regulators, who will determine minimum reserve ratios. This banking system is used by financial institutions in most countries. This type of banking system is common in the United States and many other free-trading countries.

The formation of fractional reserve banking system

Fractional reserve banking The creation of the system began around 1668, when Sweden established the world's first central bank, Riksbank, but the original form of fractional reserves had been used long before that. The idea that deposits could grow and expand, and that loans could penetrate the economy, quickly caught on. The government has also found it sensible to use existing resources to encourage consumption rather than hoarding them in coffers.

After Sweden took steps to make the practice more formal, the fractional reserve system took hold and spread rapidly. The United States established a central bank twice, first in 1791 and second in 1861, but unfortunately neither lasted long. Finally, in 1913, the United States created the Federal Reserve Bank, now the Central Bank of the United States, under the Federal Reserve Act. The financial institution's stated goal at the time was to stabilize, maximize, and monitor the economy in terms of pricing, employment, and interest rates.

How does the system work?

When a customer deposits funds into a bank account, these funds are no longer the depositor's property (at least not direct property). The bank now owns the funds and, in turn, gives the customer a deposit account from which to withdraw funds. This means that bank customers will withdraw all their deposits in accordance with the bank's established rules and procedures. However, when a bank receives deposits, it does not retain all of those funds. Instead, only a small portion of deposits are held in banks (fractional reserves). This part of the reserve is generally between 3% and 10%, and the remaining funds will be used by banks to issue loans. [1] 

Use this simple example to see how new money is created when these loans are made:

1. Customer A deposits $50,000 in Bank 1. Bank 1 issued a loan of US$45,000 to Customer B
2. Customer B deposited US$45,000 in Bank 2. Bank 2 issued a loan of US$40,500 to customer C
3. Customer C deposited US$40,500 in bank 3. Bank 3 issued a loan of US$36,450 to customer D
4. Customer D deposited US$36,450 in bank 4. Bank 4 issued a loan of US$32,805 to customer E
5. Customer E deposited US$32,805 in bank 5. Bank 5 issued a loan of US$29,525 to customer F

 With the deposit reserve ratio of 10%, the initial deposit of US$50,000 has grown to US$234,280. Available currencies, and this is the total of all customer deposits. This is a very simple example showing the multiplier effect under the partial reserve banking system, but it has clearly demonstrated the basic idea.

But please note that this is a process based on debt principal. Deposit accounts represent the funds (liabilities) owed by the bank to customers, and interest-bearing loans are the bank's most profitable business and are also the bank's assets. Simply put, banks create money by generating more loan account assets rather than deposit account (liabilities).

What is a "bank run"?

What if everyone decided to withdraw all their money in the bank? This situation is also known as a bank run. Since banks are only required to retain a small part of their customers' deposits, they may have difficulty meeting their financial obligations in this situation, which directly leads to bank failure.

For the fractional reserve system to work properly, it is necessary to avoid depositors not showing up at the bank at the same time to withdraw their deposits. While bank runs have occurred before, they were not caused by customers' wishes. Typically, customers only try to withdraw all their deposits if they believe the bank is in serious trouble.

The "Great Depression" in the United States is an example of the devastating damage caused by large-scale withdrawals. Today's banks hold reserves to prevent such a situation from happening again. There are many banks whose deposit reserve ratios exceed the legal minimum reserve ratio. They use this method to better meet the needs of customers in withdrawing account assets.

The advantages and disadvantages of fractional reserve banking system

Enjoy this high While most of the advantages of the profit model are included, a small part of the advantages are gradually benefiting customers through earning interest on deposit accounts. Government agencies are also part of the system, and usually governments praise the fractional reserve system for promoting consumption, maintaining economic stability, and providing economic growth.

On the other hand, many economists believe that the fractional reserve system is unsustainable and carries great risks-especially considering the current crisis. Current monetary policy in most countries is based on credit/debt, not real money. The economic system we rely on is based on trust in banks and their fiat currencies.

Fractional Reserve Banking System and Cryptocurrency

With Traditional Unlike fiat currency systems, Bitcoin was created as a decentralized digital currency, which gave rise to an alternative economic framework that works completely differently.

Like most cryptocurrencies, Bitcoin is maintained by a distributed network of nodes. All data is protected by cryptographic evidence and stored in a distributed ledger called the blockchain. And this means that there is no need for a central bank or a major authority.  

In addition, the issuance of Bitcoin is limited, which means that no more new tokens will be generated after reaching 21 million Bitcoins. Therefore, fractional reserves do not exist in the world of Bitcoin and cryptocurrencies because the environment is different.