Fractional Reserve Banking - Economic Function

Economic Function

Fractional-reserve banking permits a bank to make loans against the reserves it takes in as demand deposits. Full-reserve banking would not permit lending from demand deposits. Fractional-reserve banks can thus offer demand accounts, which provide immediate liquidity to depositors, and also provide longer-term loans to borrowers, and act as financial intermediaries for those funds. Less liquid forms of deposit (such as time deposits) or riskier classes of financial assets (such as equities or long-term bonds) may lock up a depositor's wealth for a period of time, making it unavailable for use on demand. This "borrowing short, lending long," or maturity transformation function of fractional-reserve banking is a role that many economists consider to be an important function of the commercial banking system.

Additionally, according to macroeconomic theory, a well-regulated fractional-reserve bank system also benefits the economy by providing regulators with powerful tools for influencing the money supply and interest rates. Many economists believe that these should be adjusted by government to promote various public policy objectives.

Modern central banking allows banks to practice fractional-reserve banking with inter-bank business transactions with a reduced risk of bankruptcy. 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.