What is "fractional reserve lending" and why is it driving our modern banking?

Few concepts are as fundamental - and as widely misunderstood - in global finance as "fractional reserve lending". They are the silent engine that drives modern credit creation, liquidity and economic growth, but they also pose a systemic risk if misunderstood or mismanaged.

Basically. fractional reserve lending refers to the practice where commercial banks must hold only a portion of customer deposits in reserveswhile the rest is used for credit or investment purposes. This system allows banks to create new credit by multiplying original deposits throughout the economy - a process known as the money multiplier effect, deposit multiplication.

For example, if a customer deposits EUR 1 000, the bank can only keep 10 % (EUR 100) and lend the remaining EUR 900. This €900 can be re-deposited and re-loaned several times, making thousands of loans from a single initial deposit. While this stimulates economic activity, it is also heavily dependent on public confidence, careful liquidity management and central bank supervision.

Unlike historical systems that mandated fixed reserve ratios, today's modern regulations - such as the liquidity coverage ratio (LCR) and Net Stable Funding Ratio (NSFR) under Basel III and IV - focus on ensuring that banks are able to meet short- and long-term obligations even in stressed situations.

However, the fractional model means that the depositors are in fact unsecured creditorsbecause deposits become liabilities of the bank. In crisis situations, such as the global financial meltdown in 2008 or the Cyprus banking crisis in 2013, this financial structure can become more volatile. Yet this system remains the global standard - allowing credit expansion, financial intermediation and capital formation on a scale that no other model currently matches.

At a time when central banks are exploring the future money through central bank digital currencies (CBDC) and proposals for close banking, the debate about how much leverage and risk should exist in deposit-based systems is once again coming to the fore. As long as the public trusts the banking sector, the basis of the world's monetary architecture still remains fractional reserve banking - efficient, powerful and finely balanced.

Read more in the first part of our gnews.cz series

Part one: The global bond market crash: why a 40-year era of stability is over and what it means for you. Read more here

Part two: Who is the real owner of your bank deposits? Under EU law, it's not you. Read more here

Part three: Do you have money in your bank account? The legal truth across the EU and what happens to your money in a banking crisis. Read more here

gnews.cz - GH