Section 5: Banks’ Balance Sheets and Fractional Reserve Banking

A Bank’s Balance Sheet

To understand banks’ reserve requirements and fractional reserve banking, let’s study a bank’s balance sheet.

The table below includes entries for a hypothetical bank’s assets and liabilities. Assets are investments and properties that a bank owns. Liabilities are what a bank owes. A typical bank may show the following entries on its balance sheet (the amounts depend, of course, on the size of the bank and its specific transactions).

For the above bank, total checkable deposits (money in transactions accounts) equals $70 million. If the bank’s required reserves are 10% of all checkable deposits, then this bank must keep at least $7 million in cash or as deposits with the Fed. Its cash plus deposits with the Fed currently equal $10 million, so this bank can still loan out $3 million. This $3 million is called “excess reserves.”

Fractional Reserve Banking

For our purposes, in order to understand fractional reserve banking, it is sufficient to consider a simplified balance sheet, which includes only total reserves and loans on the asset side, and checkable deposits (funds deposited by the bank’s clients into their transaction accounts) on the liability side.

The following balance sheet shows a bank with $4,000 of deposits, $400 in total reserves, and $3,600 in loans.

Total Reserves           $400

Checkable Deposits          $4,000

Loans                    $3,600

Until recently, banks have been required to keep a fraction of customers’ deposits on hand in the form of cash (total reserves). This is called fractional reserve banking.

In the above example, the bank has $400 in total reserves. If a central bank requires commercial banks to keep 10% of their deposited money, then banks  are required to keep 10% of $4,000 in their vaults. Therefore, required reserves are $400. Because total reserves are $400, the bank cannot make any further loans. In other words, the bank’s excess reserves are $0.

Currently, the reserve requirement in the United States is zero percent. This means that banks are allowed to loan out all of its customers’ deposits. In reality, banks do hold on to a fraction of its customers’ deposits though.

Our system of fractional reserve banking is built on the assumption that even on a bad day, on balance, customers typically do not withdraw more than 5 or 10% of deposits. Typically, on an average day, deposits cancel out against withdrawals. On good days, deposits exceed withdrawals.

A Run on the Bank

What would happen if a bank has 10% of customers’ deposits on hand, and, on balance, more than 10% of the bank’s deposited amount is withdrawn on a certain day? Or, what if all of the bank’s customers decided to withdraw all of their deposited funds at once (a run on the bank)? In this case, the bank will not have sufficient funds to meet the demand. This, of course is a serious problem for the bank, and usually requires intervention by the Federal Reserve System. The Fed can choose to loan the bank the needed reserves, if it believes that the problem is temporary and can be solved. Or it can suggest a merger with a larger, healthier bank, if it believes that the bank’s problems are more structural and long-lived. In the worst case scenario, the bank will go bankrupt. In this case, account holders insured by the FDIC (see Section 7 of this unit) or a private deposit insurance company will receive their deposited funds up to a certain maximum amount ($250,000 per account for FDIC insured banks).

In the next section, we will learn how deposits of new money result in an increase in the nation’s money supply. As we will see, the increase in the nation’s money supply is a multiple of the initial new deposit. This is called the money creation process.