History
Fractional-reserve banking predates the existence of governmental monetary authorities and originated many centuries ago in bankers' discovery that depositors generally do not all demand payment at the same time.
Savers looking to keep their valuables in safekeeping depositories deposited gold and silver at goldsmiths, receiving in exchange a note for their deposit (see Bank of Amsterdam). These notes gained acceptance as a medium of exchange for commercial transactions and thus became as an early form of circulating paper money.
As the notes were used directly in trade, the goldsmiths observed that people would not usually redeem all their notes at the same time, and they saw the opportunity to invest their coin reserves in interest-bearing loans and bills. This generated income for the goldsmiths but left them with more notes on issue than reserves with which to pay them. A process was started that altered the role of the goldsmiths from passive guardians of bullion, charging fees for safe storage, to interest-paying and interest-earning banks. Thus fractional-reserve banking was born.
However, if creditors (note holders of gold originally deposited) lost faith in the ability of a bank to their notes, many would try to redeem their notes at the same time. If in response a bank could not raise enough funds by calling in loans or selling bills, it either went into insolvency or defaulted on its notes. Such a situation is called a bank run and caused the demise of many early banks.
Starting in the late 1600s nations began to establish central banks which were given the legal power to set reserve requirements and to issue the reserve assets, or monetary base, in which form such reserves are required to be held. The reciprocal of the reserve requirement, called the money multiplier, limits the size to which the transactions in money supply may grow for a given level of reserves in the banking system. In order to mitigate the impact of bank failures and financial crises, governments created central banks – public (or semi-public) institutions that have the authority to centralize the storage of precious metal bullion amongst private banks to allow transfer of gold in case of bank runs, regulate commercial banks, impose reserve requirements, and act as lender-of-last-resort if any bank faced a bank run. The emergence of central banks reduced the risk of bank runs inherent in fractional-reserve banking and allowed the practice to continue as it does today.
Over time, economists, central banks, and governments have changed their views as to the policy variables which should be targeted by monetary authorities. These have included interest rates, reserve requirements, and various measures of the money supply and monetary base.
Read more about this topic: Fractional Reserve Banking
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