Fractional reserve is a banking system that allows commercial banks to profit by loaning part of their customers’ deposits, while just a small fraction of these deposits are stored as real cash and available for withdrawal. Practically speaking, this banking system creates money out of nothing using a percentage of their customers’ bank deposits.

How does it work?

When a customer deposits money in their bank account, that money is no longer the depositor’s property, at least not directly. The bank now owns it, and in return, they give their customer a deposit account that they can draw on. This means their bank customer should have access to their full deposit amount upon demand, with established bank rules and procedures.
However, when the bank takes possession of the deposited money, it doesn’t hold on to the full amount. Instead, a small percentage of the deposit is reserved (a fractional reserve). This reserve amount typically ranges from 3% to 10% and the rest of the money is used to issue loans to other customers.

Consider how these loans create new money with this simplified example:

  1. Customer A deposits $50,000 in Bank 1. Bank 1 loans Customer B $45,000
  2. Customer B deposits $45,000 in Bank 2. Bank 2 loans Customer C $40,500
  3. Customer C deposits $40,500 in Bank 3. Bank 3 loans Customer D $36,450
  4. Customer D deposits $36,450 in Bank 4. Bank 4 loans Customer E $32,805
  5. Customer E deposits $32,805 in Bank 5. Bank 5 loans Customer F $29,525

With a fractional reserve requirement of 10%, that original $50,000 deposit has grown to $234,280 in total available currency, which is the sum of all customers’ deposits plus $29,525. While this is a very simplified example of the way fractional reserve banking generates money via the multiplier effect, it demonstrates the basic idea.

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Advantages and Disadvantages of Fractional Reserve Banking

While banks enjoy most of the advantages of this highly lucrative system, a tiny bit of this trickles down to bank customers when they earn interest on their deposit accounts. Governmental are also part of the scheme and often defend that fractional reserve banking systems encourage spending and provide economic stability and growth.

On the other hand, many economists believe that the fractional reserve scheme is unsustainable and quite risky – especially if we consider that the current monetary system, implemented by most countries, is actually based on credit/debt and not on real money. The economic system we have relies on the premise that people trust both the banks and the fiat currency, established as legal tender by the governments.

Fractional Reserve Banking and Cryptocurrency

In contrast with the traditional fiat currency system, Bitcoin was created as a decentralized digital currency, giving birth to an alternative economic framework that works in an entirely different way.

Just like most cryptocurrencies, Bitcoin is maintained by a distributed network of nodes. All data is protected by cryptographic proofs and recorded on a public distributed ledger called blockchain. This means that there is no need for a central bank and there is no authority in charge.

Also, the issuance of Bitcoin is finite so that no more coins will be generated after the max supply of 21 million units is reached. Therefore, the context is totally different and there is no such a thing as fractional reserve in the world of Bitcoin and cryptocurrencies.

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This article originally appeared on Binance Academy