Fractional Reserve Banking
To begin with, fractional reserve banking (FRB) is a banking regime in which banks accept money from customers in return for demand claims on the same amount, without maintaining enough reserves (money unallocated to any loan or other enterprise) to redeem all of the claims at any one time. As a side note, base money consists of cash and reserves held by financial institutions with the central bank. Furthermore, a bank maintains a fraction of the money it has promised in reserve, in the hope that it will be able to redeem all claims that occur in practice because only a small number of demands for redemption will be made at any one time. The difference between the money accepted and the money retained in reserve is invested in loans or assets, with the returns being legally pocketed by the bank. Although in modern banking law, the amount of money tendered by the customer is not in any legal sense a deposit, by tradition the account balance is referred to as such. Fractional reserve banking, and the right to refer to what is actually a loan contract as a "deposit" contract are currently legal and practiced by all commercial banks.
In addition, the practice of fractional reserve banking expands the broad money supply. The definition of broad money is basically the cash circulating in the economy, plus the credit derived from the "deposits". Due to the prevalence of fractional reserve banking, the broad money supply is a large multiple of the amount of base money - the amount of specie held in the banks' vaults in the case of a "hard" monetary regime, or cash plus bank reserves in the case of a fiat monetary regime. This multiple is known as the money multiplier and it's influenced by several factors. Foremostly, each bank's managers are motivated to maintain sufficient reserves to handle any likely simultaneous rush of demands for withdrawal or drafts. In a liberal economy, the law respects a bank customer's property rights, shutting down the bank and distributing its owner's capital to make good on its contracts the moment it fails to make good on its contract. Taking the case of a society where bankers are granted special privileges by legally sanctioning "suspension of payments of specie" like the early U.S., there are costs in terms of reputation lost. Secondly, they are highly motivated to maintain the trust of their stockholders and creditors. Finally, they may be limited by the reserve requirement or other financial ratio requirements imposed by financial regulators. Prior to 2008 in the U.S., banks were in practice regulated by this last factor, the reserve requirement. Since then it has been irrelevant.
In legal terms, instead of a demand deposit being considered a bailment contract with the bank being the custodian of the funds deposited as trustee for the depositor with fiduciary duties not to embezzle or misappropriate the funds, banks since the 19th century have been allowed to consider the deposit (available for withdrawal on demand) "their money", and they are able to do with the money as they wish, provided they recognize the deposit as a general liability on their books of account. In the current legal framework, the depositor no longer "owns" any money when the demand deposit is made. The depositor is merely an unsecured creditor, relying on the central bank to bail out the bank should a bank run occur, with no further recourse against the bank.
The alternative to fractional reserve banking is "100% reserve banking" or full reserve banking where banks treat demand deposits in a similar way to allocated gold accounts, where the money cannot be lent out since the money is held in trust on behalf of the client. In this system, only those funds from depositors who consent to provide their money with the bank for an extended period (so called "time depositors" or "term depositors") would be available for lending to third party borrowers.
In addition, the practice of fractional reserve banking expands the broad money supply. The definition of broad money is basically the cash circulating in the economy, plus the credit derived from the "deposits". Due to the prevalence of fractional reserve banking, the broad money supply is a large multiple of the amount of base money - the amount of specie held in the banks' vaults in the case of a "hard" monetary regime, or cash plus bank reserves in the case of a fiat monetary regime. This multiple is known as the money multiplier and it's influenced by several factors. Foremostly, each bank's managers are motivated to maintain sufficient reserves to handle any likely simultaneous rush of demands for withdrawal or drafts. In a liberal economy, the law respects a bank customer's property rights, shutting down the bank and distributing its owner's capital to make good on its contracts the moment it fails to make good on its contract. Taking the case of a society where bankers are granted special privileges by legally sanctioning "suspension of payments of specie" like the early U.S., there are costs in terms of reputation lost. Secondly, they are highly motivated to maintain the trust of their stockholders and creditors. Finally, they may be limited by the reserve requirement or other financial ratio requirements imposed by financial regulators. Prior to 2008 in the U.S., banks were in practice regulated by this last factor, the reserve requirement. Since then it has been irrelevant.
In legal terms, instead of a demand deposit being considered a bailment contract with the bank being the custodian of the funds deposited as trustee for the depositor with fiduciary duties not to embezzle or misappropriate the funds, banks since the 19th century have been allowed to consider the deposit (available for withdrawal on demand) "their money", and they are able to do with the money as they wish, provided they recognize the deposit as a general liability on their books of account. In the current legal framework, the depositor no longer "owns" any money when the demand deposit is made. The depositor is merely an unsecured creditor, relying on the central bank to bail out the bank should a bank run occur, with no further recourse against the bank.
The alternative to fractional reserve banking is "100% reserve banking" or full reserve banking where banks treat demand deposits in a similar way to allocated gold accounts, where the money cannot be lent out since the money is held in trust on behalf of the client. In this system, only those funds from depositors who consent to provide their money with the bank for an extended period (so called "time depositors" or "term depositors") would be available for lending to third party borrowers.