Question

Fractional reserve banking is inherently unstable. Comment.

Answer 1

Q- Fractional reserve banking is inherently unstable. Comment.

Answer- A bank run is not an "extraordinary", "unusual", or "unexpected" event in finance, but a predictable event that merely reveals the reality of banking - that fractional reserve banking is inherently unstable and that such banks are inherently insolvent.

The main problem is how to make the transition between the two systems. If abolishing fractional reserve banking would force banks to increase their reserves, or reduce the number of loans, this would lead to many businesses having to repay their debts. It would also shrink the money supply, risking deflation. There is always some risk you may lose your deposit, but usually the risk-adjusted return is positive. In fact, the only type of banking that is sustainable is fractional reserve banking. You put your money in the bank, the bank keeps 100% reserves in its vaults, there are no loans.

Key takeaways

• Banks are required to keep on hand a certain amount of the cash that depositors give them, but banks are not required to keep the entire amount on hand.
• Most banks are required to keep 10% of the deposit, referred to as reserves.
• Some banks are exempt from holding reserves, but all banks are paid a rate of interest on reserves.

Fractional Reserve Requirements

Depository institutions must report their transaction accounts, time and savings deposits, vault cash, and other reservable obligations to the Fed either weekly or quarterly. Some banks are exempt from holding reserves, but all banks are paid a rate of interest on reserves called the "interest rate on reserves" (IOR) or the "interest rate on excess reserves" (IOER). This rate acts as an incentive for banks to keep excess reserves.

Banks with less than $16.3 million in assets are not required to hold reserves. Banks with assets of less than $124.2 million but more than $16.3 million have a 3% reserve requirement, and those banks with more than $124.2 million in assets have a 10% reserve requirement.

In America's fractional reserve banking system banks are required to keep a fraction of their deposits in reserve but may loan or invest the rest of the money (i.e., excess reserves) for a prudent business purpose.