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January 21, 2009

Fractional reserve banking

Banks serve a vital function of taking money from depositers and loaning it out to businesses, homebuyers and other borrowers, but is there something in the nature of this banking system that makes it susceptible to financial ups and downs?

Dr. Mike Walden, North Carolina Cooperative Extension economist in the College of Agriculture and Life Sciences at N.C. State University, responds:

"This is a big debate within the economics profession. Some economists say the answer to your question is a definite 'yes,' and it's based on a concept called the fractional reserve system or fractional reserve banking. And what this simply means is that when depositers take money to the bank, the bank puts that in the vault. The bank is going to loan out most of that money, and indeed, when they do that, they're going to create money, and they're going to create more money, so they have more loans outstanding than they have back in the vault. Now, that works well when those outstanding loans perform, when the bank earns interest on those loans. The bank makes money. Their depositers make money. But it, perhaps, creates a problem when a significant part of those loans go belly up, that is, they don't perform. And the losses can be multiplied because the losses can actually end up being more than what the bank has back in the vault. You may remember the scene from the story 'It's a Wonderful Life,' where Jimmy Stewart's character is trying to convince people in the lobby who want their money out, 'Hey, we don't have all your money back here. It's been loaned out.' So some economists say that this system really creates big ups and downs in the financial sector, and indeed, can in the whole economy. That's one reason why the Federal Reserve was established as sort of a backstop where banks who are in trouble can go to get emergency loans."

Posted by Dave at January 21, 2009 08:00 AM