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A fractional reserve system is a system of banking in which commercial banks only keep a fraction of the money they hold in a central bank. This modern banking system is used throughout most of the world in some form or another. While this system is the most popular commercial banking arrangement, it is not without risks. One major risk of engaging in the fractional reserve system is that a collapse may be caused by a bank run on institutions participating in this form of banking.
Commonly referred to simply as an FRS, a fractional reserve system allows banks to keep a portion of their money supply for the purposes of making loans and to support customer withdrawals. In this system, only a fraction of a bank’s total cash supply is kept in a central bank in the country where the commercial bank is located. A central bank determines the minimum reserve amount and such is set forth in a monetary policy of which all banks in a particular country must adhere to.
Historically, banks have used other systems, such as backing deposits with gold. Most countries throughout the world today, however, operate by using some variation of a fractional reserve system. Due to religious beliefs against earning and collecting interest on money loaned, banks operating in Islamic countries engage in business slightly differently than do commercial banks located in other, non-Islamic countries. For the most part, some variation of the system is still used in Islamic countries, however.
Although the fractional reserve system is widely used throughout most of the world, it still is not a perfect system as the potential for a complete banking collapse is always possible. One major risk factor related to this system involves a run on the bank, where customers fearing a bank’s bankruptcy may all demand account withdrawals at the same time, thus creating a shortage of cash money available for withdrawal and, therefore, creating a sort of self-fulfilling prophecy. Such widespread activity can be triggered by financial forecasts predicting a bank’s failure and cause a mass panic among banking customers. While risks like a bank run are inherent in the fractional reserve system, many central banks are prepared for such events and provide insurance on deposits made. Some central banks are also willing to make loans to banks when a run occurs to prevent a complete collapse.