What Is Modern Fractional Reserve Banking System?


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Tariq Habib Profile
Tariq Habib answered
Profit maximizing goldsmith bankers soon recognized that although deposits are payable on demand, they are not all withdrawn together. Reserves equal to total deposits would be necessary if all depositors suddenly had to be paid off in full at the same time, but this almost never occurred. On a given day, some people make withdrawals while others make deposits. The two kinds of transactions generally balanced out.

The bankers did not need to keep 100 percent of deposits as sterile reserves; reserves earn no interest when they are sitting in a vault. So early banks hit upon the idea of using the money entrusted to them to make investments. By putting most of the money deposited with them in earning assets and keeping only fractional cash reserves against deposits, banks maximize their profits.

The transformation into fractional reserve banks holding fractional rather than 100 percent reserves against deposits was revolutionary. It enabled banks to create money. That is banks could turn each dollars of reserves into several dollars deposits. I hope this answer will satisfy your question.

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