Question

The banking system of the United States is a fractional reserve system. What dangers does this pose for the safety of the banking system?

can you answer this in a well explained paragraph thank you.

Answer 1

The new banking system (called fractional reserve banking) is built on the premise that it is very unlikely that people would need all their deposits back at once. One example of this is someone who deposits £100 into a bank. Assuming the bank has a 25 per cent reserve ratio (although it will be much lower in reality), it loans £75 to an industrial company. The £75 is deposited into the bank account of the company. The bank then uses this £75 deposit to make another £56.25 loan, and so forth, until the bank has made £300 loans backed by deposits worth £100.

If a large number of depositors unexpectedly ask for their money back and banks are unable to get their hands on enough cash to satisfy demand, the fact that deposits are a fraction of total liabilities means problems will arise. This is either due to a liquidity shortage (the assets can not be turned fast enough into cash), a solvency issue (the assets are not worth enough), or a combination of the two. If that happens, banks risk exiting business unless they are assisted by the central bank with cash.

The biggest limitation of the fractional reserve banking system is its reliance on continued confidence in the banking system itself. The demand existence of its liabilities, and the small fraction of its holding often means that the possibility of failure is constantly revealed. Even bank liquidity fear means a bank run may be caused there. Thanks to the interconnectedness of our global economy and payment process this danger can be systemic. This potentially could cause cascading failures such as seen during the great recession.