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Fractional-reserve banking is the current form of banking practiced in most countries worldwide. Fractional-reserve banking predates the existence of governmental monetary authorities and originated many centuries ago in bankers’ realization that generally not all depositors demand payment at the same time. Thus fractional-reserve banking was born. In order to mitigate the impact of bank failures and financial crises, central banks were also granted the authority to centralize banks’ storage of precious metal reserves, thereby facilitating transfer of gold in the event of bank runs, to regulate commercial banks, impose reserve requirements, and to act as lender-of-last-resort if any bank faced a bank run. The emergence of central banks reduced the risk of bank runs which is inherent in fractional-reserve banking, and it allowed the practice to continue as it does today.
In other words, the funds deposited are no longer the property of the customer. Each bank is legally authorized to issue credit up to a specified multiple of its reserves, so reserves available to satisfy payment of deposit liabilities are less than the total amount which the bank is obligated to pay in satisfaction of demand deposits. Fractional-reserve banking ordinarily functions smoothly. Relatively few depositors demand payment at any given time, and banks maintain a buffer of reserves to cover depositors’ cash withdrawals and other demands for funds. If creditors are afraid that the bank is running out of reserves or is insolvent, they have an incentive to redeem their deposits as soon as possible before other depositors access the remaining reserves. Thus the fear of a bank run can actually precipitate the crisis.
Fractional-reserve banking allows banks to create credit in the form of bank deposits, which represent immediate liquidity to depositors. The process of fractional-reserve banking expands the money supply of the economy but also increases the risk that a bank cannot meet its depositor withdrawals. Modern central banking allows banks to practice fractional-reserve banking with inter-bank business transactions with a reduced risk of bankruptcy. Simultaneously, an equal amount of new commercial bank money is created in the form of bank deposits. At least one textbook states that when a loan is made by the commercial bank, the bank is keeping only a fraction of central bank money as reserves and the money supply expands by the size of the loan.
This process is called “deposit multiplication”. However, as explained below, bank loans are only rarely made in this way. The proceeds of most bank loans are not in the form of currency. Deposits created in this way are sometimes called derivative deposits and are part of the process of creation of money by commercial banks. Issuing loan proceeds in the form of paper currency and current coins is considered to be a weakness in internal control. 100 through fractional-reserve banking with varying reserve requirements. Each curve approaches a limit.
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This limit is the value that the “money multiplier'” calculates. This theoretical maximum is never reached, because some eligible reserves are held as cash outside of banks. Rather than holding the quantity of base money fixed, central banks have recently pursued an interest rate target to control bank issuance of credit indirectly so the ceiling implied by the money multiplier does not impose a limit on money creation in practice. M3 is M2 plus large time deposits and other forms of money. In countries where fractional-reserve banking is prevalent, commercial bank money usually forms the majority of the money supply. The acceptance and value of commercial bank money is based on the fact that it can be exchanged freely at a commercial bank for central bank money.
Government regulations may also be used to limit the money creation process by preventing banks from giving out loans even though the reserve requirements have been fulfilled. Central bank support for distressed banks, and government guarantee funds for notes and deposits, both to counteract bank runs and to protect bank creditors. Reserve requirements are intended to ensure that the banks have sufficient supplies of highly liquid assets, so that the system operates in an orderly fashion and maintains public confidence. To avoid defaulting on its obligations, the bank must maintain a minimal reserve ratio that it fixes in accordance with, notably, regulations and its liabilities. In practice this means that the bank sets a reserve ratio target and responds when the actual ratio falls below the target.
As with reserves, other sources of liquidity are managed with targets. The ability of the bank to borrow money reliably and economically is crucial, which is why confidence in the bank’s creditworthiness is important to its liquidity. This means that the bank needs to maintain adequate capitalisation and to effectively control its exposures to risk in order to continue its operations. If creditors doubt the bank’s assets are worth more than its liabilities, all demand creditors have an incentive to demand payment immediately, causing a bank run to occur. These residual contractual maturities may be adjusted to account for expected counter party behaviour such as early loan repayments due to borrowers refinancing and expected renewals of term deposits to give forecast cash flows.
This analysis highlights any large future net outflows of cash and enables the bank to respond before they occur. Scenario analysis may also be conducted, depicting scenarios including stress scenarios such as a bank-specific crisis. 25,482m, for a cash reserve ratio of 11. However, other important financial ratios are also used to analyze the bank’s liquidity, financial strength, profitability etc. It is important how the term ‘reserves’ is defined for calculating the reserve ratio, as different definitions give different results. Other important financial ratios may require analysis of disclosures in other parts of the bank’s financial statements.