Question

Certain economists argue that fractional reserve banking is fraudulent or unethical. Make an argument in support of this statement. Now make an argument against this statement.

Answer 1

Answer- Fractional reserve banking system is a banking system where the banks are supposed to keep some amount of the people’s deposits as reserves with them or with the federal bank. The rate of reserves is set depending upon the exonomies situation. In simple words if a person deposits $1000 in a bank then the bank can’t lend thw whole $1000 to someone, instead the bank has to keep a certain portion of such $1000 as reserves with them and can lend the rest.

If a high rate of such reserves are set then the money flow in the economy is lessened and if low rate for such reserves is set then the money flow in the economy grows.

Fractional reserve banking is said to be fradulent by some because it is believed by those people that in a banking system the function of bank is to accept deposits and lend the momey thus creating a continuous flow of money in the economy. Also generating incoe by the way of interest on loans and advances. But when the bank keeps a fraction of deposits as reserves it acts as a Non productive asset for the bank. It is so because it acts as a cash in hand which is liquid asset and produces no income for the bank.

A major reason for the unethical practice is that people deposit money in banks and are told that their money is safe with the banks and they can take their money out whenever they want. But this is not true because if all the people take their money out they won’t get their full money back because significant portion of their money is being lent out. This creates a problem of unstability and people might think banking system as not a solid one.

Also if out of all the banks one bank lents out money to a firm and somehow that money isn’t returned then the investment gets wasted by the bank and people may start to think of a bank as not being stable and thus running out of money and they may also not think of it as a safe and sound place for their money.

Another weakness of fractional reserve system is that it gives the provate bank more power and control and this creates the problem in the times of recession and boom. During recession banks want to lend more money to people and lower it’s interest rate so as to increase the momey suppy but people will make less deposits in banks due to recession and this leaves banks with low money as they have to keep a fraction of it as reserves also. The opposite is true for boom.

The fractional reserve system creates a problem for banks when they moderate the situation in the times for recession and boom.

But on the other hand if we see the fractional reserve sustem with a different perspective then we can notice that it helps in creation of money in the economy. Eg. A person deposits $100 and the bank lends $90 to another customer and keeps $10 as reserves and let us suppose that this new customer purchases a fridge for the same amount borrowed and the vendor of the fridge deposits this $90 in bank. The bank again keeps $9 as reserves and lends out $81 to another new customer. This process goes on and thus it leads to money creation and circulation in the economy.

Another advantage is that the private banks are insured by FDIC, so if banks are somehownot able to return the money on demand then the federal bank helps the private banks in paying off their loans.