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April 18, 2015 

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REALISM OF PERFECT COMPETITION: Perfect competition is an idealized market structure that does NOT exist in the real world. While some real world industries might come relatively close to a one or two of the four key characteristics of perfect competition, none matches all four sufficiently that we can declare a perfectly competitively industry. Some industries come close on the large number of small firms and the identical product characteristics. A few industries have relatively good, although not perfect, information about prices and technology. However, almost all industries fall far short of the perfect mobility characteristics.

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FRACTIONAL-RESERVE BANKING:

A method of banking activity in which banks keep less than 100 percent of their deposits in the form of bank reserves and use the rest for interest-paying loans. Fractional-reserve banking makes it possible for banks to function as profit-seeking financial intermediaries (matching up lenders and borrowers) while ensuring the safety and liquidity of deposits, especially checkable deposits that are part of the economy's money supply.
The modern banking system practices what is termed fractional-reserve banking. Banks keep only a fraction of their deposits set aside as reserves to conduct day-to-day transactions. These reserves take the form of either cash in the bank (vault cash) or deposits with Federal Reserve Banks (Federal Reserve deposits). The reminder of the deposits are used for interest-paying loans.

Fractional-reserve banking makes it possible for banks to simultaneously act as financial intermediaries, matching up borrowers and lenders, and maintain the safety and liquidity of financial wealth, especially the checkable deposits portion of the money supply.

Two Goals

Fractional-reserve banking makes it possible for banks to pursue two goals, that is, to provide two valuable services for the economy.
  • Profitability: Banks pursue profit as a financial intermediary with revenue generated from interest on loans. Because banks are profit-seeking businesses, they must receive revenue to generate profit and to remain in business. They do this primary through interest charged for lending.

  • Safekeeping: Banks pursue safety of deposits and money supply stability by keeping a portion of deposit in reserve. As depository institutions, banks acquire the funds used for lending through deposits. Banks must keep customer deposits safe or they have no funds that can be used for interest-generating loans.
Banks must balance these two goals. Focusing too much on profitability is likely to limit the ability to keep deposits safe. Focusing too much on safekeeping is likely to limit the ability to generate profit.

One of the most important consequence of this balancing act is business-cycle instability. Banks that fall short of the either profitability or safekeeping are prone to bankruptcy. If banks go out of business, then a part of the economy's money supply could, quite literally, vanish into thin air, triggering a business-cycle contraction.

Reserves

Reserves are the key to fractional-reserve banking. Reserves are the deposits that banks literally hold in "reserve" to satisfy customer withdrawals. In the modern banking system, especially for the U.S. economy, reserves consist of either vault cash or deposits at Federal Reserve Banks. Some of these "legal" reserves are "required" by the government to back up deposits and the rest are "excess" that can be used for loans.
  • Legal Reserves: Legal reserves are the TOTAL of vault cash and Federal Reserve deposits. These two assets are the only two assets that satisfy the legal reserve requirements handed down by government regulators. And the reason these assets are used to satisfy legal reserve requirements is that these are the two assets banks that are used for daily operations--such as cashing or processing checks or generally satisfying deposit withdrawals. Legal reserves can also be thought of as total reserves.

  • Required Reserves: Required reserves are the amount of reserves--vault cash and Federal Reserve deposits--that regulators require banks to keep for daily transactions. Required reserves are specified as a fraction of outstanding deposits--usually about 1 to 3 percent depending on the size of the bank or the type of deposits.

  • Excess Reserves: Any legal (or total) reserves over and above those required are excess reserves. These excess reserves are exceedingly important to the banking industry. Because reserves do not generate interest, add to revenue, or enhance profit, banks are prone to hold as few reserves as possible. Banks hold enough reserves to satisfy reserve requirements, because they have to. But they try NOT to hold excess reserves. Holding excess reserves means lost interest revenue. Excess reserves are then used to make profit-generating loans.

Full or No

Fractional-reserve banking is the standard practice used by banks throughout the global economy. However, to fully understand the nature of this method, consider the two alternatives to fractional-reserve banking: full-reserve banking and no-reserve banking.
  • Full-Reserve Banking: With this alternative, banks keep 100 percent of all deposits in reserve. In effect, bank vaults are filled with the cash deposited by customers. In effect, banks function as storage businesses. With full-reserve banking, the safekeeping goal is well served. Customers are able to retrieve their deposits. However, banks cannot function as financial intermediaries. They do not make loans. And with no loans that generate interest, they need to obtain revenue in other ways, presumably by charging for the storage of deposits.

    With full-reserve banking, the temptation to use the stockpiles of cash locked away in bank vaults is enormous. Businesses, consumers, government agencies, and even the bank itself undoubtedly are motivated to use this cash, to borrow this wealth for capital investment, home construction, car purchases, or government spending. But if banks give in to this temptation, then they are back into the financial intermediary business, and fractional-reserve banking.


  • No-Reserve Banking: With this alternative, banks keep 0 percent of deposits in reserve. Every dollar of deposits received by banks is used for loans. In effect, banks are nothing more than a broker or agent that matches up borrowers and lenders. In fact, they probably have no need for a vault. With no-reserve banking, the profit goal is well served as a financial intermediary, as long as customers continue to make deposits. However, the deposit safekeeping goal is NOT well served. Banks are NOT able to satisfy withdrawal requests from customers, at least not in a timely fashion. With NO reserves, banks cannot "cash" checks. And if customers cannot withdraw funds they are not as likely to deposit funds. If banks have NO deposits then they can make NO loans or function as financial intermediaries.

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Recommended Citation:

FRACTIONAL-RESERVE BANKING, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2015. [Accessed: April 18, 2015].


Check Out These Related Terms...

     | banks | banking | reserves | traditional banks | savings and loan associations | credit unions | mutual savings banks | thrift institutions | excess reserves | legal reserves | required reserves | vault cash | Federal Reserve deposits | full-reserve banking | no-reserve banking |


Or For A Little Background...

     | money | M1 | profit | industry | monetary economics | government functions | financial markets | liquidity |


And For Further Study...

     | money creation | Federal Reserve System | Federal Deposit Insurance Corporation | Comptroller of the Currency | central bank | monetary policy | bank panic | monetary aggregates | barter |


Related Websites (Will Open in New Window)...

     | Federal Reserve System | Federal Deposit Insurance Corporation | Comptroller of the Currency |


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