Fractional reserve banking is a fundamental concept that unveils the inner workings of the financial system and the transformations it has undergone over time in the United States. Let’s delve into the details.
Exploring Fractional Reserve Banking
Fractional reserve banking is a financial system in which banks, including credit unions, reserve a portion of their customers’ funds, often referred to as deposits. They can then utilize the remainder to extend loans and, to a lesser extent, invest. To illustrate this concept, imagine depositing $1,000 into your savings account, with the bank keeping 10% in reserves, which amounts to $100. The remaining $900 is lent to another customer. This process continues as the borrowed money circulates, effectively allowing banks to create new money within the economy.
The Role of the Federal Reserve
The United States’ central bank, commonly known as the Federal Reserve or the Fed, has historically imposed specific reserve requirements on banks, typically ranging from 3% to 10% of funds held in transaction accounts like checking accounts. These percentages varied according to the bank’s size. Banks could meet these requirements in two ways: by holding cash as vault cash or by maintaining funds in an account at the Federal Reserve, known as a reserve balance.
In March 2020, the Federal Reserve altered the reserve requirement ratio, reducing it to 0%, effectively eliminating the need for banks to maintain reserves. Although the Fed currently has no plans to change this, the ratio remains adjustable. It’s important to note that many banks continue to hold reserves voluntarily, even in the absence of a Federal Reserve mandate.
Diverse Funding Sources
Customer deposits aren’t the sole source of funding that banks can employ for loans. Banks can also borrow from other banks and the Federal Reserve to manage their short-term business needs, such as facilitating payments and financing consumer loans. Interbank borrowing overnight is influenced by the federal funds rate, as banks strive to maintain equilibrium between short-term bank deposits, which customers can withdraw at any time, and the long-term loans they provide.
U.S. Fractional Reserve Banking: A Modern Perspective
Fractional reserve banking is just one facet of how the U.S. banking system operates. In contemporary banking, the emphasis on reserves and reserve requirements has diminished. Instead, banks adhere to capital and liquidity requirements, designed to fortify their ability to weather potential economic crises. In simple terms, capital serves as a financial cushion to absorb losses, while liquidity signifies the bank’s capacity to meet financial obligations promptly.
Research conducted by the New York Fed suggests that the current risk-based approach, integrating capital and liquidity requirements, is more effective in regulating banks’ leverage than a system primarily concentrated on reserves or reserve requirements. Leverage, simply put, pertains to using borrowed capital for investments.
A Brief Historical Overview of Reserve Requirements: 1863 to 2023
Reserve requirements have a long history, predating the establishment of a national currency. The National Bank Act of 1863 ushered in nationwide reserve requirements, mandating that banks with national charters maintain reserves amounting to 25% of their deposits.
The initial idea behind reserve requirements was to guarantee that deposits could be swiftly converted into cash for the entire banking system. However, bank runs and panics in the late 1800s and early 1900s challenged this notion. Bank runs occurred when people rushed to withdraw their funds, fearing that their banks would fail.
To manage spikes in the public’s demand for cash, the Federal Reserve Act of 1913 established the Federal Reserve System, designating the Federal Reserve as the lender of last resort to distressed U.S. banks. Over time, the Fed expanded its role in ensuring economic stability and growth, leading to revisions in reserve requirements.
Since 1913, the Federal Reserve’s reserve ratio has fluctuated significantly, ranging from 0% to as high as 26%. These fluctuations were contingent on account types, deposit sizes, and the geographic locations of banks. Notably, the 0% reserve ratio has remained unchanged since late March 2020.
Transformation of Reserve Management: Before and After 2008
Prior to the financial crisis of 2008, the Federal Reserve relied on three monetary policy tools to control interest rates and steer the economy: open market operations, reserve requirements, and the discount rate. The management of reserves was crucial in influencing interest rates.
Pre-2008 Monetary Policy Tools
- Open Market Operations: The Fed engaged in buying and selling government securities, like Treasury bonds, in an open market to adjust the supply of reserve balances. Purchasing these securities injected money into the economy, while selling them reduced the money supply.
- Reserve Requirements: These requirements maintained banks’ demand for reserves at a consistent level, adapting to changing economic conditions. Banks with excess reserves would lend to those in need using the federal funds rate to meet their reserve requirements overnight.
- The Discount Rate: This rate allowed banks to borrow from the Fed in emergencies, although it was a costlier option compared to borrowing from other banks. There was a certain stigma attached to borrowing from the Fed, leading banks to seek alternative options. The discount rate acted as an upper limit on banks’ borrowing costs.
The Federal Reserve managed the supply of reserves in such a way that minor adjustments could impact the Fed rate when necessary. If the economy required stimulus, the Fed lowered the federal funds rate, effectively increasing the supply of reserves and reducing the discount rate. A lower Fed rate made borrowing cheaper for banks and their customers, stimulating spending and fostering economic growth.
Conversely, during periods of high inflation, such as the early 1980s, the Fed reduced reserves and raised the discount rate, making lending more expensive and less accessible. A higher Fed rate served to discourage both banks and consumers from borrowing excessively.
Post-2008 Monetary Policy
The financial crisis of 2007-2009 necessitated a shift from a “limited” to an “ample” reserves framework for the Federal Reserve. Instead of solely relying on reserves, the Fed now manipulates the Fed rate using three distinct rates. The focus was on promoting recovery by maintaining a low Fed rate and a substantial level of reserves, rendering reserve requirements obsolete as a policy tool.
To control the Fed rate, the central bank introduced a set of new tools, including paying interest on reserve balances. Prior to 2008, reserves were a financial liability for banks, as these funds could not generate any interest income. However, after 2008, the Fed began remunerating banks for maintaining reserve balances. Consequently, banks today possess more reserves than before the financial crisis.
The three key rates that now regulate the Fed rate are:
- Interest on Reserves: This is the primary method through which the Fed manages the federal funds rate. Banks have an incentive to lend reserves at rates exceeding what the Fed offers on reserves; otherwise, there is little motivation to lend to one another.
- Overnight Reverse Repurchase Agreement Rate: This rate determines what banks and nonbank financial institutions can earn on deposits from the Fed overnight. It ensures that nonbanks cannot lend money at rates below the Fed rate, as interest on reserves is exclusively for banks. This rate establishes a minimum for all institutions