Loan

A loan is a type of debt. This article focuses exclusively on monetary loans, although, in practice, any material object might be lent. Like all debt instruments, a loan entails the redistribution of financial assets over time, between the lender and the borrower.

The borrower initially does receive an amount of money from the lender, which they pay back, usually but not always in regular installments, to the lender. This service is generally provided at a cost, referred to as interest on the debt. A loan is of the annuity type if the amount paid periodically (for paying off and interest together) is fixed.

A borrower may be subject to certain restrictions known as loan covenants under the terms of the loan.

Acting as a provider of loans is one of the principal tasks for financial institutions. For other institutions, issuing of debt contracts such as bonds is a typical source of funding. Bank loans and credit are one way to increase the money supply.

Legally, a loan is a contractual promise of a debtor to repay a sum of money in exchange for the promise of a creditor to give another sum of money।

Types of loans

Secured

A secured loan is a loan in which the borrower pledges some asset (e.g. a car or property) as collateral for the loan.

A mortgage loan is a very common type of debt instrument, used by many individuals to purchase housing. In this arrangement, the money is used to purchase the property. The financial institution, however, is given security — a lien on the title to the house — until the mortgage is paid off in full. If the borrower defaults on the loan, the bank would have the legal right to repossess the house and sell it, to recover sums owing to it.

In some instances, a loan taken out to purchase a new or used car may be secured by the car, in much the same way as a mortgage is secured by housing. The duration of the loan period is considerably shorter — often corresponding to the useful life of the car. There are two types of auto loans, direct and indirect. A direct auto loan is where a bank gives the loan directly to a consumer. An indirect auto loan is where a car dealership acts as an intermediary between the bank or financial institution and the consumer.

A type of loan especially used in limited partnership agreements is the recourse note.

A stock hedge loan is a special type of securities lending whereby the stock of a borrower is hedged by the lender against loss, using options or other hedging strategies to reduce lender risk.^{[citation needed]}

Unsecured

Unsecured loans are monetary loans that are not secured against the borrowers assets. These may be available from financial institutions under many different guises or marketing packages:

• credit card debt
• personal loans
• bank overdrafts
• credit facilities or lines of credit
• corporate bonds

The interest rates applicable to these different forms may vary depending on the lender and the borrower. These may or may not be regulated by law. In the United Kingdom, when applied to individuals, these may come under the Consumer Credit Act 1974.

Abuses in lending

Predatory lending is one form of abuse in the granting of loans. It usually involves granting a loan in order to put the borrower in a position that one can gain advantage over him or her. Where the moneylender is not authorised, it could be considered a loan shark.

Usury is a different form of abuse, where the lender charges excessive interest. In different time periods and cultures the acceptable interest rate has varied, from no interest at all to unlimited interest rates. Credit card companies in some countries have been accused by consumer organisations of lending at usurious interest rates and making money out of frivolous "extra charges". ^[1]

Abuses can also take place in the form of the customer abusing the lender by not repaying the loan or with an intent to defraud the lender.

United States taxes

Most of the basic rules governing how loans are handled for tax purposes in the United States are uncodified by both Congress (the Internal Revenue Code) and the Treasury Department (Treasury Regulations — another set of rules that interpret the Internal Revenue Code).^[2] Yet such rules are universally accepted.^[3]

1. A loan is not gross income to the borrower.^[4] Since the borrower has the obligation to repay the loan, the borrower has no accession to wealth.^[5]

2. The lender may not deduct the amount of the loan.^[6] The rationale here is that one asset (the cash) has been converted into a different asset (a promise of repayment).^[7] Deductions are not typically available when an outlay serves to create a new or different asset.^[8]

3. The amount paid to satisfy the loan obligation is not deductible by the borrower.^[9]

4. Repayment of the loan is not gross income to the lender.^[10] In effect, the promise of repayment is converted back to cash, with no accession to wealth by the lender.^[11]

5. Interest paid to the lender is included in the lender’s gross income.^[12] Interest paid represents compensation for the use of the lender’s money or property and thus represents profit or an accession to wealth to the lender.^[13] Interest income can be attributed to lenders even if the lender doesn’t charge a minimum amount of interest.^[14]

6. Interest paid to the lender may be deductible by the borrower.^[15] In general, interest paid in connection with the borrower’s business activity is deductible, while interest paid on personal loans are not deductible.^[16] The major exception here is interest paid on a home mortgage.^[17]

Income from discharge of indebtedness

Although a loan does not start out as income to the borrower, it becomes income to the borrower if the borrower is discharged of indebtedness. ^[18] Thus, if a debt is discharged, then the borrower essentially has received income equal to the amount of the indebtedness. The Internal Revenue Code lists “Income from Discharge of Indebtedness” in Section 62(a)(12) as a source of gross income.

Example: X owes Y $50,000. If Y discharges the indebtedness, then X no longer owes Y $50,000. For purposes of calculating income, this should be treated the same way as if Y gave X $50,000.

For a more detailed description of the “discharge of indebtedness”, look at Section 108 (Cancellation of Debt (COD) Income) of the Internal Revenue Code.^[19]

Deposit account

A deposit account is a current account at a banking institution that allows money to be deposited and withdrawn by the account holder, with the transactions and resulting balance being recorded on the bank's books. Some banks charge a fee for this service, while others may pay the customer interest on the funds deposited.

Although restrictions placed on access depend upon the terms and conditions of the account and the provider, the account holder retains rights to have their funds repaid on demand. The customer may or may not be able to pay the funds in the account by cheque, internet banking, EFTPOS or other channels depending on those provided by the bank and offered or activated in respect of the account.

The banking terms "deposit" and "withdrawal" tend to obscure the economic substance and legal essence of transactions in a deposit account. From a legal and financial accounting standpoint, the term deposit is used by the banking industry in financial statements to describe the liability owed by the bank to its depositor, and not the funds (whether cash or checks) themselves, which are shown an asset of the bank. For example, a depositor opening a checking account at a bank in the United States with $100 in currency surrenders legal title to the $100 in cash, which becomes an asset of the bank. On the bank's books, the bank debits its "currency and coin on hand" account for the $100 in cash, and credits a liability account (called a "demand deposit" account, "checking" account, etc.) for an equal amount. (See Double-entry bookkeeping system.) In the audited financial statements of the bank, on the balance sheet, the $100 in currency would be shown as an asset of the bank on the left side of the balance sheet, and the deposit account would be shown as a liability owed by the bank to its customer, on the right side of the balance sheet. The bank's financial statement reflects the economic substance of the transaction -- which is the bank has actually borrowed $100 from its depositor and has contractually obliged itself to repay the customer according to the terms of the demand deposit account agreement. To offset this deposit liability, the bank now owns the actual, physical funds deposited, and shows those funds as an asset of the bank.

Typically, an account provider will not hold the entire sum in reserve, but will loan the money at interest to other clients, in a process known as fractional-reserve banking. It is this process which allows providers to pay out interest on deposits.

By transferring the ownership of deposits from one party to another, they can replace physical cash as a method of payment. In fact, deposits account for most of the "money supply" in use today. For example, if a bank in the United States makes a loan to a customer by "depositing" the loan proceeds in the customer's checking account, the bank typically records this event by debiting an asset account on the bank's books (called loans receivable or some similar name) and credits the deposit liability or checking account of the customer on the bank's books. From an economic standpoint, the bank has essentially created "economic money" (although obviously not legal tender). The customer's checking account balance has no "dollar bills" in it, as a demand deposit account is simply a liability owed by the bank to its customer. In this way, commercial banks are allowed to increase the money supply (without printing currency, or legal tender).

Regulatory protection

Main article: Banking regulation

Banks are normally subject to prudential regulation which has the purpose of reducing the risk of failure of the bank. It may also have the purpose of reducing the extent of depositor losses in the event of bank failure.

Main article: Deposit insurance

Bank deposits may also be insured by a deposit insurance scheme, if applicable.

Types of deposit account

• Demand account
• Savings deposit
• Time deposit

Central bank

A central bank, reserve bank, or monetary authority is the entity responsible for the monetary policy of a country or of a group of member states. Its primary responsibility is to maintain the stability of the national currency and money supply, but more active duties include controlling subsidized-loan interest rates, and acting as a "bailout" lender of last resort to the banking sector during times of financial crisis (private banks often being integral to the national financial system). It may also have supervisory powers, to ensure that banks and other financial institutions do not behave recklessly or fraudulently.

Most richer countries today have an "independent" central bank, that is, one which operates under rules designed to prevent political interference. Examples include the European Central Bank and the U.S. Federal Reserve। Some central banks are publicly owned, and others are privately owned. In practice, there is little difference between public and private ownership, since in the latter case almost all profits of the bank are paid to the government either as a tax or a transfer to the government.

Activities and responsibilities

The ECB building in Frankfurt

Hong Kong Monetary Authority, housed in the International Finance Centre, Hong Kong's de facto central bank.

The Reserve Bank of India, central bank of the India

The Bank of England, central bank of the United Kingdom

US Federal Reserve

Central Bank of Brazil in Brasília

Functions of a central bank (not all functions are carried out by all banks):

• implementation of monetary policy
• controls the nation's entire money supply
• the Government's banker and the bankers' bank ("Lender of Last Resort")
• manages the country's foreign exchange and gold reserves and the Government's stock register;
• regulation and supervision of the banking industry:
• setting the official interest rate - used to manage both inflation and the country's exchange rate - and ensuring that this rate takes effect via a variety of policy mechanisms

Monetary policy

Central banks implement a country's chosen monetary policy. At the most basic level, this involves establishing what form of currency the country may have, whether a fiat currency, gold-backed currency (disallowed for countries with membership of the IMF), currency board or a currency union. When a country has its own national currency, this involves the issue of some form of standardized currency, which is essentially a form of promissory note: a promise to exchange the note for "money" under certain circumstances. Historically, this was often a promise to exchange the money for precious metals in some fixed amount. Now, when many currencies are fiat money, the "promise to pay" consists of nothing more than a promise to pay the same sum in the same currency.

In many countries, the central bank may use another country's currency either directly (in a currency union), or indirectly, by using a currency board. In the latter case, local currency is directly backed by the central bank's holdings of a foreign currency in a fixed-ratio; this mechanism is used, notably, in Hong Kong and Estonia.

In countries with fiat money, monetary policy may be used as a shorthand form for the interest rate targets and other active measures undertaken by the monetary authority.

Currency issuance

Many central banks are "banks" in the sense that they hold assets (foreign exchange, gold, and other financial assets) and liabilities. A central bank's primary liabilities are the currency outstanding, and these liabilities are backed by the assets the bank owns.

Central banks generally earn money by issuing currency notes and "selling" them to the public for interest-bearing assets, such as government bonds. Since currency usually pays no interest, the difference in interest generates income. In most central banking systems, this income is remitted to the government. The European Central Bank remits its interest income to its owners, the central banks of the member countries of the European Union.

Although central banks generally hold government debt, in some countries the outstanding amount of government debt is smaller than the amount the central bank may wish to hold. In many countries, central banks may hold significant amounts of foreign currency assets, rather than assets in their own national currency, particularly when the national currency is fixed to other currencies.

Naming of central banks

There is no standard terminology for the name of a central bank, but many countries use the "Bank of Country" form (e.g., Bank of England, Bank of Canada, Bank of Russia). Some are styled "national" banks, such as the National Bank of Ukraine; but the term "national bank" is more often used by privately-owned commercial banks, especially in the United States. In other cases, central banks may incorporate the word "Central" (e.g. European Central Bank, Central Bank of Ireland). Many countries have state-owned banks or other quasi-government entities that have entirely separate functions, such as financing imports and exports.

In some countries, particularly in some Communist countries, the term national bank may be used to indicate both the monetary authority and the leading banking entity, such as the USSR's Gosbank (state bank). In other countries, the term national bank may be used to indicate that the central bank's goals are broader than monetary stability, such as full employment, industrial development, or other goals.

The word "Reserve" is also used, primarily in the Australia, India, New Zealand, South Africa and U.S.

Interest rate interventions

Typically a central bank controls certain types of short-term interest rates. These influence the stock- and bond markets as well as mortgage and other interest rates. The European Central Bank for example announces its interest rate at the meeting of its Governing Council (in the case of the Federal Reserve, the Board of Governors).

Both the Federal Reserve and the ECB are composed of one or more central bodies that are responsible for the main decisions about interest rates and the size and type of open market operations, and several branches to execute its policies. In the case of the Fed, they are the local Federal Reserve Banks, for the ECB they are the national central banks.

Interest rate interventions are the most common and are dealt with in more detail below.

Limits of enforcement power

Contrary to popular perception, central banks are not all-powerful and have limited powers to put their policies into effect. Most importantly, although the perception by the public may be that the "central bank" controls some or all interest rates and currency rates, economic theory (and substantial empirical evidence) shows that it is impossible to do both at once in an open economy. Robert Mundell's "impossible trinity" is the most famous formulation of these limited powers, and postulates that it is impossible to target monetary policy (broadly, interest rates), the exchange rate (through a fixed rate) and maintain free capital movement. Since most Western economies are now considered "open" with free capital movement, this essentially means that central banks may target interest rates or exchange rates with credibility, but not both at once.

Even when targeting interest rates, most central banks have limited ability to influence the rates actually paid by private individuals and companies. In the most famous case of policy failure, George Soros arbitraged the pound sterling's relationship to the ECU and (after making $2B himself and forcing the UK to spend over $8B defending the pound) forced it to abandon its policy. Since then he has been a harsh critic of clumsy bank policies and argued that no one should be able to do what he in fact did.

The most complex relationships are those between the yuan and the US dollar, and between the Euro and its neighbours. The situation in Cuba is so exceptional as to require the Cuban peso to be dealt with simply as an exception, since the US forbids direct trade with Cuba. US dollars were ubiquitous in Cuba's economy after its legalization in 1991, but were officially removed from circulation in 2004 and replaced by the Convertible peso.

Policy instruments

The main monetary policy instruments available to central banks are open market operation, bank reserve requirement, interest rate policy, re-lending and re-discount (including using the term repurchase market), and credit policy (often coordinated with trade policy). While capital adequacy is important, it is defined and regulated by the Bank for International Settlements, and central banks in practice generally do not apply stricter rules.

To enable open market operations, a central bank must hold foreign exchange reserves (usually in the form of government bonds) and official gold reserves. It will often have some influence over any official or mandated exchange rates: Some exchange rates are managed, some are market based (free float) and many are somewhere in between ("managed float" or "dirty float").

Interest rates

By far the most visible and obvious power of many modern central banks is to influence market interest rates; contrary to popular belief, they rarely "set" rates to a fixed number. Although the mechanism differs from country to country, most use a similar mechanism based on a central bank's ability to create as much fiat money as required.

The mechanism to move the market towards a 'target rate' (whichever specific rate is used) is generally to lend money or borrow money in theoretically unlimited quantities, until the targeted market rate is sufficiently close to the target. Central banks may do so by lending money to and borrowing money from (taking deposits from) a limited number of qualified banks, or by purchasing and selling bonds. As an example of how this functions, the Bank of Canada sets a target overnight rate, and a band of plus or minus 0.25%. Qualified banks borrow from each other within this band, but never above or below, because the central bank will always lend to them at the top of the band, and take deposits at the bottom of the band; in principle, the capacity to borrow and lend at the extremes of the band are unlimited.^[1] Other central banks use similar mechanisms.

It is also notable that the target rates are generally short-term rates. The actual rate that borrowers and lenders receive on the market will depend on (perceived) credit risk, maturity and other factors. For example, a central bank might set a target rate for overnight lending of 4.5%, but rates for (equivalent risk) five-year bonds might be 5%, 4.75%, or, in cases of inverted yield curves, even below the short-term rate. Many central banks have one primary "headline" rate that is quoted as the "Central bank rate." In practice, they will have other tools and rates that are used, but only one that is rigorously targeted and enforced.

"The rate at which the central bank lends money can indeed be chosen at will by the central bank; this is the rate that makes the financial headlines." - Henry C.K. Liu, in an Asia Times article explaining modern central bank function in detail He explains further that "the US central-bank lending rate is known as the Fed funds rate. The Fed sets a target for the Fed funds rate, which its Open Market Committee tries to match by lending or borrowing in the money market.... a fiat money system set by command of the central bank. The Fed is the head of the central-bank snake because the US dollar is the key reserve currency for international trade. The global money market is a US dollar market. All other currencies markets revolve around the US dollar market." Accordingly the US situation isn't typical of central banks in general.

A typical central bank has several interest rates or monetary policy tools it can set to influence markets.

• Marginal Lending Rate (currently 5.00% in the Eurozone) A fixed rate for institutions to borrow money from the CB.(In the US this is called the Discount rate).
• Main Refinancing Rate (4.25% in the Eurozone) This is the publicly visible interest rate the central bank announces. It is also known as Minimum Bid Rate and serves as a bidding floor for refinancing loans. (In the US this is called the Federal funds rate).
• Deposit Rate (3.00% in the Eurozone) The rate parties receive for deposits at the CB.

These rates directly affect the rates in the money market, the market for short term loans.

Open market operations

Through open market operations, a central bank influences the money supply in an economy directly. Each time it buys securities, exchanging money for the security, it raises the money supply. Conversely, selling of securities lowers the money supply. Buying of securities thus amounts to printing new money while lowering supply of the specific security.

The main open market operations are:

• Temporary lending of money for collateral securities ("Reverse Operations" or "repurchase operations", otherwise known as the "repo" market). These operations are carried out on a regular basis, where fixed maturity loans (of 1 week and 1 month for the ECB) are auctioned off.
• Buying or selling securities ("direct operations") on ad-hoc basis.
• Foreign exchange operations such as forex swaps.

All of these interventions can also influence the foreign exchange market and thus the exchange rate. For example the People's Bank of China and the Bank of Japan have on occasion bought several hundred billions of U.S. Treasuries, presumably in order to stop the decline of the U.S. dollar versus the Renminbi and the Yen.

Capital requirements

All banks are required to hold a certain percentage of their assets as capital, a rate which may be established by the central bank or the banking supervisor. For international banks, including the 55 member central banks of the Bank for International Settlements, the threshold is 8% (see the Basel Capital Accords) of risk-adjusted assets, whereby certain assets (such as government bonds) are considered to have lower risk and are either partially or fully excluded from total assets for the purposes of calculating capital adequacy. Partly due to concerns about asset inflation and repurchase agreements, capital requirements may be considered more effective than deposit/reserve requirements in preventing indefinite lending: when at the threshold, a bank cannot extend another loan without acquiring further capital on its balance sheet.

Reserve requirements

Another significant power that central banks hold is the ability to establish reserve requirements for other banks. By requiring that a percentage of liabilities be held as cash or deposited with the central bank (or other agency), limits are set on the money supply.

In practice, many banks are required to hold a percentage of their deposits as reserves. Such legal reserve requirements were introduced in the nineteenth century to reduce the risk of banks overextending themselves and suffering from bank runs, as this could lead to knock-on effects on other banks. See also money multiplier, Ponzi scheme. As the early 20th century gold standard and late 20th century dollar hegemony evolved, and as banks proliferated and engaged in more complex transactions and were able to profit from dealings globally on a moment's notice, these practices became mandatory, if only to ensure that there was some limit on the ballooning of money supply. Such limits have become harder to enforce. The People's Bank of China retains (and uses) more powers over reserves because the yuan that it manages is a non-convertible currency.

Even if reserves were not a legal requirement, prudence would ensure that banks would hold a certain percentage of their assets in the form of cash reserves. It is common to think of commercial banks as passive receivers of deposits from their customers and, for many purposes, this is still an accurate view.

This passive view of bank activity is misleading when it comes to considering what determines the nation's money supply and credit. Loan activity by banks plays a fundamental role in determining the money supply. The money deposited by commercial banks at the central bank is the real money in the banking system; other versions of what is commonly thought of as money are merely promises to pay real money. These promises to pay are circulatory multiples of real money. For general purposes, people perceive money as the amount shown in financial transactions or amount shown in their bank accounts. But bank accounts record both credit and debits that cancel each other. Only the remaining central-bank money after aggregate settlement - final money - can take only one of two forms:

• physical cash, which is rarely used in wholesale financial markets,
• central-bank money.

The currency component of the money supply is far smaller than the deposit component. Currency and bank reserves together make up the monetary base, called M1 and M2.

Exchange requirements

To influence the money supply, some central banks may require that some or all foreign exchange receipts (generally from exports) be exchanged for the local currency. The rate that is used to purchase local currency may be market-based or arbitrarily set by the bank. This tool is generally used in countries with non-convertible currencies or partially-convertible currencies. The recipient of the local currency may be allowed to freely dispose of the funds, required to hold the funds with the central bank for some period of time, or allowed to use the funds subject to certain restrictions. In other cases, the ability to hold or use the foreign exchange may be otherwise limited.

In this method, money supply is increased by the central bank when the central bank purchases the foreign currency by issuing (selling) the local currency. The central bank may subsequently reduce the money supply by various means, including selling bonds or foreign exchange interventions.

Margin requirements and other tools

In some countries, central banks may have other tools that work indirectly to limit lending practices and otherwise restrict or regulate capital markets. For example, a central bank may regulate margin lending, whereby individuals or companies may borrow against pledged securities. The margin requirement establishes a minimum ratio of the value of the securities to the amount borrowed.

Central banks often have requirements for the quality of assets that may be held by financial institutions; these requirements may act as a limit on the amount of risk and leverage created by the financial system. These requirements may be direct, such as requiring certain assets to bear certain minimum credit ratings, or indirect, by the central bank lending to counterparties only when security of a certain quality is pledged as collateral.

Examples of use

The People's Bank of China has been forced into particularly aggressive and differentiating tactics by the extreme complexity and rapid expansion of the economy it manages. It imposed some absolute restrictions on lending to specific industries in 2003, and continues to require 1% more (7%) reserves from urban banks (typically focusing on export) than rural ones. This is not by any means an unusual situation. The US historically had very wide ranges of reserve requirements between its dozen branches. Domestic development is thought to be optimized mostly by reserve requirements rather than by capital adequacy methods, since they can be more finely tuned and regionally varied.

Banking supervision and other activities

In some countries a central bank through its subsidiaries controls and monitors the banking sector. In other countries banking supervision is carried out by a government department such as the UK Treasury, or an independent government agency (eg UK's Financial Services Authority). It examines the banks' balance sheets and behaviour and policies toward consumers. Apart from refinancing, it also provides banks with services such as transfer of funds, bank notes and coins or foreign currency. Thus it is often described as the "bank of banks".

Many countries such as the United States will monitor and control the banking sector through different agencies and for different purposes, although there is usually significant cooperation between the agencies. For example, money center banks, deposit-taking institutions, and other types of financial institutions may be subject to different (and occasionally overlapping) regulation. Some types of banking regulation may be delegated to other levels of government, such as state or provincial governments.

Any cartel of banks is particularly closely watched and controlled. Most countries control bank mergers and are wary of concentration in this industry due to the danger of groupthink and runaway lending bubbles based on a single point of failure, the credit culture of the few large banks.

Independence

Over the past decade, there has been a trend towards increasing the independence of central banks as a way of improving long-term economic performance. However, while a large volume of economic research has been done to define the relationship between central bank independence and economic performance, the results are ambiguous.

Advocates of central bank independence argue that a central bank which is too susceptible to political direction or pressure may encourage economic cycles ("boom and bust"), as politicians may be tempted to boost economic activity in advance of an election, to the detriment of the long-term health of the economy and the country. In this context, independence is usually defined as the central bank’s operational and management independence from the government. On the other hand, an independent central bank can, and has been proven in the past to have done as such (The Great Depression), create a boom & bust scenario for the profit of the owners & shareholders of the bank itself.

The literature on central bank independence has defined a number of types of independence.

Legal Independence: The independence of the central bank is enshrined in law. This type of independence is limited in a democratic state; in almost all cases the central bank is accountable at some level to government officials, either through a government minister or directly to a legislature. Even defining degrees of legal independence has proven to be a challenge since legislation typically provides only a framework within which the government and the central bank work out their relationship.

Goal Independence: The central bank has the right to set its own policy goals, whether inflation targeting, control of the money supply, or maintaining a fixed exchange rate. While this type of independence is more common, many central banks prefer to announce their policy goals in partnership with the appropriate government departments. This increases the transparency of the policy setting process and thereby increases the credibility of the goals chosen by providing assurance that they will not be changed without notice. In addition, the setting of common goals by the central bank and the government helps to avoid situations where monetary and fiscal policy are in conflict; a policy combination that is clearly sub-optimal.

Operational Independence: The central bank has the independence to determine the best way of achieving its policy goals, including the types of instruments used and the timing of their use. This is the most common form of central bank independence. The granting of independence to the Bank of England in 1997 was, in fact, the granting of operational independence; the inflation target continued to be announced in the Chancellor’s annual budget speech to Parliament.

Management Independence: The central bank has the authority to run its own operations (appointing staff, setting budgets, etc) without excessive involvement of the government. The other forms of independence are not possible unless the central bank has a significant degree of management independence. One of the most common statistical indicators used in the literature as a proxy for central bank independence is the “turn-over-rate” of central bank governors. If a government is in the habit of appointing and replacing the governor frequently, it clearly has the capacity to micro-manage the central bank through its choice of governors.

It is argued that an independent central bank can run a more credible monetary policy, making market expectations more responsive to signals from the central bank. Recently, both the Bank of England (1997) and the European Central Bank have been made independent and follow a set of published inflation targets so that markets know what to expect. Even the People's Bank of China has been accorded great latitude due to the difficulty of problems it faces, though in the People's Republic of China the official role of the bank remains that of a national bank rather than a central bank, underlined by the official refusal to "unpeg" the yuan or to revalue it "under pressure". PBoC independence can thus be read more as independence from the US which rules the financial markets, not from the Communist Party of China which rules the country. The fact that the CPoC is not elected also relieves the pressure to please people, increasing its independence.

Governments generally have some degree of influence over even "independent" central banks; the aim of independence is primarily to prevent short-term interference. For example, the chairman of the U.S. Federal Reserve Bank is appointed by the President of the U.S. (all nominees for this post are recommended by the owners of the Federal Reserve, as are all the board members), and his choice must be confirmed by the Congress.

International organizations such as the World Bank, the BIS and the IMF are strong supporters of central bank independence. This results, in part, from a belief in the intrinsic merits of increased independence. The support for independence from the international organizations also derives partly from the connection between increased independence for the central bank and increased transparency in the policy-making process. The IMF’s FSAP review self-assessment, for example, includes a number of questions about central bank independence in the transparency section. An independent central bank will score higher in the review than one that is not independent.

History

In Europe prior to the 17th century most money was commodity money, typically gold or silver. However, promises to pay were widely circulated and accepted as value at least five hundred years earlier in both Europe and Asia. The medieval European Knights Templar ran probably the best known early prototype of a central banking system, as their promises to pay were widely regarded, and many regard their activities as having laid the basis for the modern banking system. At about the same time, Kublai Khan of the Mongols introduced fiat currency to China, which was imposed by force by the confiscation of specie.

The oldest central bank in the world is the Riksbank in Sweden, which was opened in 1668 with help from Dutch businessmen. This was followed in 1694 by the Bank of England, created by Scottish businessman William Paterson in the City of London at the request of the English government to help pay for a war. The US Federal Reserve was created by the U.S. Congress through the passing of the Glass-Owen Bill, signed by President Woodrow Wilson on December 23, 1913.

The People's Bank of China evolved its role as a central bank starting in about 1979 with the introduction of market reforms in that country, and this accelerated in 1989 when the country took a generally capitalist approach to developing at least its export economy. By 2000 the PBoC was in all senses a modern central bank, and emerged as such partly in response to the European Central Bank. This is the most modern bank model and was introduced with the euro to coordinate the European national banks, which continue to separately manage their respective economies other than currency exchange and base interest rates.

Fractional-reserve banking

Fractional-reserve banking is the banking practice in which banks are required to keep only a fraction of their deposits in reserve with the choice of lending out the remainder while maintaining the obligation to redeem all deposits upon demand. This practice is universal in modern banking.^[1][2]

History

At one time, people deposited gold coins and silver coins at goldsmiths, receiving in turn a note for their deposit. Once these notes became a trusted medium of exchange an early form of paper money was born, in the form of the goldsmiths' notes.^[3]

As the notes were used directly in trade, the goldsmiths noted that people would not usually redeem all their notes at the same time, and saw the opportunity to invest coin reserves in interest-bearing loans and bills. This left the goldsmiths with more notes on issue than reserves to pay them with. This generated income—a process that altered their role from passive guardians of bullion charging fees for safe storage, to interest-paying and earning banks. Fractional-reserve banking was born.

However, if creditors (note holders of gold originally deposited) lost faith in the ability of a bank to redeem (pay) their notes, many would try to redeem their notes at the same time. If in response, a bank could not raise enough funds by calling in loans or selling bills, it either went into insolvency or defaulted on its notes. Such a situation is called a bank run and caused the demise of many early banks.^[3] Modern banking systems insure public deposits in the event of a bank failure, and thereby avoid bank runs.

Purpose and function

The United States' Federal Reserve gives a summary of why fractional reserve banking is used and what its effects are:

The fact that banks are required to keep on hand only a fraction of the funds deposited with them is a function of the banking business. Banks borrow funds from their depositors (those with savings) and in turn lend those funds to the banks’ borrowers (those in need of funds). Banks make money by charging borrowers more for a loan (a higher percentage interest rate) than is paid to depositors for use of their money. If banks did not lend out their available funds after meeting their reserve requirements, depositors might have to pay banks to provide safekeeping services for their money. For the economy and the banking system as a whole, the practice of keeping only a fraction of deposits on hand has an important cumulative effect. Referred to as the fractional reserve system, it permits the banking system to "create" money.^[4]

How it works

A demand deposit at a bank (e.g. checking account) or banknote issued by a bank (bank-issued paper money) is essentially a loan to the bank, repayable on demand, which the bank uses to finance its investments in loans and interest bearing securities. The nature of fractional-reserve banking is that there is only a fraction of cash reserves available at the bank needed to repay all of the demand deposits and banknotes issued. The reason people deposit funds at a bank or hold banknotes issued by a bank is to store savings in the form of a demand claim on the bank. One important aspect of fractional-reserve banking is that the note holders and depositors still have a claim to repayment of their funds on demand even though the funds are already largely invested by the bank in interest bearing loans and securities.^[5]

For instance, you could ask to withdraw all the money in your checking account at any time. If all the depositors of a bank did that at the same time (a bank run), the bank could be in trouble, though this rarely happens. However, the Northern Rock crisis of 2007 in the United Kingdom is an example of such an event.

Fractional-reserve banking works because:

1. Over any typical period of time, redemption demands are largely or wholly offset by new deposits or issues of notes. The bank thus needs only to satisfy the excess amount of redemptions.
2. Only a minority of people will actually choose to withdraw their demand deposits or present their notes for payment at any given time.
3. People usually keep their funds in the bank for a prolonged period of time.
4. There are usually enough cash reserves in the bank to handle net redemptions.

If the net redemption demands are unusually large, the bank will run low on reserves and will be forced to raise new funds from additional borrowings (e.g. by borrowing from the money market or using lines of credit held with other banks), and/or sell assets, to avoid running out of reserves and defaulting on its obligations. If creditors are afraid that the bank is running out of cash, they have an incentive to redeem their deposits as soon as possible, triggering a bank run.

Money creation

The process of fractional-reserve banking has a cumulative effect of money creation by banks.^[4] In short, there are two types of money in a fractional-reserve banking system:^[6][7][8]

1. central bank money (physical currency such as coins and paper money)
2. commercial bank money (money created through loans) - sometimes referred to as checkbook money^[9]

When a loan is funded with central bank money, new commercial bank money is created. As a loan is paid back, the commercial bank money disappears from existence.

The table below displays how loans are funded and how the money supply is affected. It also shows how central bank money is used to create commercial bank money. An initial deposit of $100 of central bank money is lent out 10 times with a fractional-reserve rate of 20%. This means that of the initial $100, 20 percent of it, or $20, is set aside as reserves while the remaining 80 percent, or $80, is loaned out. The recipient of the $80 then spends that money. The receiver of that $80 then deposits it into a bank. The bank then sets aside 20 percent of that $80, or $16, as reserves and lends out the remaining $64. As the process continues, more commercial bank money is created. To simplify the table, a different bank is used for each deposit. In the real world, the money a bank lends may end up in the same bank so it then has more money to lend out.

Table Sources: ^{[10][11][12][6]}

Individual Bank	Amount Deposited	Lent Out	Reserves
A	100	80	20
B	80	64	16
C	64	51.20	12.80
D	51.20	40.96	10.24
E	40.96	32.77	8.19
F	32.77	26.21	6.55
G	26.21	20.97	5.24
H	20.97	16.78	4.19
I	16.78	13.42	3.36
J	13.42	10.74	2.68
K	10.74
			Total Reserves:
			89.26
	Total Amount Deposited:	Total Amount Lent Out:	Total Reserves + Last Amount Deposited:
	457.05	357.05	100
	Commercial Bank Money Created + Central Bank Money:	Commercial Bank Money Created:	Central Bank Money:
	457.05	357.05	100

The expansion of $100 of central bank money through fractional-reserve lending with a 20% reserve rate. $400 of commercial bank money is created virtually through loans.

Although no new money was physically created in addition to the initial $100 deposit, new commercial bank money is created through loans. The 2 boxes marked in red show the location of the original $100 deposit throughout the entire process. The total reserves plus the last deposit (or last loan, whichever is last) will always equal the original amount, which in this case is $100. As this process continues, more commercial bank money is created. The amounts in each step decrease towards a limit. If a graph is made showing the accumulation of deposits, one can see that the graph is curved and approaches a limit. This limit is the maximum amount of money that can be created with a given reserve rate. When the reserve rate is 20%, as in the example above, the maximum amount of total deposits that can be created is $500 and the maximum amount of commercial bank money that can be created is $400.

For an individual bank, the deposit is considered a liability whereas the loan it gives out and the reserves are considered assets. The deposit will always be equal to the loan plus the reserve, since the loan and reserve are created from the deposit. This is the basis for a bank's balance sheet.

The creation and destruction of commercial bank money occurs through this process. Whether it is created or destroyed depends on what direction the process moves. When loans are given out, the process moves from the top down and money is created. When loans are paid back, the process moves from the bottom to the top and commercial bank money is canceled out, effectively erasing it from existence.

This table gives an outline of the makeup of money supplies worldwide. Most of the money in any given money supply consists of commercial bank money.^[6] The value of commercial bank money comes from the fact that it can be exchanged at a bank for central bank money.^[6][7]

This is a general outline of how it works. The actual increase in the money supply through this process may be lower, as (at each step) banks may choose to hold reserves in excess of the statutory minimum, borrowers may let some funds sit idle, and some borrowers may choose to hold cash, and there may be delays or frictions in the process.^[13] It may also be higher if the reserve requirement is lower or if there are no reserve requirements^[14]. Government regulations may also be used to limit the money creation process by preventing banks from giving out loans even though the reserve requirements have been fulfilled.^[15]

Money multiplier

The expansion of $100 through fractional-reserve banking with varying reserve requirements. Each curve approaches a limit. This limit is the value that the money multiplier calculates.

The most common mechanism used to measure this increase in the money supply is typically called the money multiplier. It calculates the maximum amount of money that an initial deposit can be expanded to with a given reserve ratio.

Formula

The money multiplier, m, is the inverse of the reserve requirement, R:^[16]

Example

For example, with the reserve ratio of 20 percent, this reserve ratio, R, can also be expressed as a fraction:

So then the money multiplier, m, will be calculated as:

This number is multiplied by the initial deposit to show the maximum amount of money it can be expanded to.

Reserve requirements

The reserve requirements are intended to prevent banks from:

1. generating too much money by making too many loans against the narrow money deposit base;
2. having a shortage of cash when large deposits are withdrawn (although the reserve is a legal minimum, it is understood that in a crisis or bank run, reserves may be made available on a temporary basis).

The money creation process is affected by the currency drain ratio (the propensity of the public to hold banknotes rather than deposit them with a commercial bank), and the safety reserve ratio (excess reserves beyond the legal requirement that commercial banks voluntarily hold—usually a small amount). Data for "excess" reserves and vault cash are published regularly by the Federal Reserve in the United States.^[17] In practice, the actual money multiplier varies over time, and may be substantially lower than the theoretical maximum.^[18]

Financial ratios

In addition to reserve requirements, there are other financial ratios that affect how many loans a bank can fund. The capital ratio is one type of ratio. It is also important to note that the term 'reserves' in the reserve ratio generally does not include all liquid assets.^{[citation needed]}

Money supplies around the world

Main articles: Money supply and Inflation

Fractional-reserve banking determines the relationship between the amount of central bank money (currency) in the official money supply statistics and the total money supply. Most of the money in these systems is commercial bank money . Fractional reserve banking involves the issuance and creation of commercial bank money, which increases the money supply through the deposit creation multiplier. The issue of money through the banking system as a mechanism of monetary transmission, which a central bank can influence indirectly by raising or lowering interest rates (although banking regulations may also be adjusted to influence the money supply, depending on the circumstances).

Components of US money supply (currency, M1, M2, and M3) since 1959. In January 2007, the amount of central bank money was $750.5 billion while the amount of commercial bank money (in the M2 supply) was $6.33 trillion.

Components of the euro money supply 1998-2007

Regulation

Because the nature of fractional-reserve banking involves the possibility of bank runs, central banks have been created throughout the world to address these problems.^[19][20]

Central banks

Main article: Central bank

Government controls and bank regulations related to fractional-reserve banking have generally been used to impose restrictive requirements on note issue and deposit taking on the one hand, and to provide relief from bankruptcy and creditor claims, and/or protect creditors with government funds, when banks defaulted on the other hand. Such measures have included:

1. Minimum required reserve ratios (RRRs)
2. Minimum capital ratios
3. Government bond deposit requirements for note issue
4. 100% Marginal Reserve requirements for note issue, such as the Peels Act 1844 (UK)
5. Sanction on bank defaults and protection from creditors for many months or even years, and
6. Central bank support for distressed banks, and government guarantee funds for notes and deposits, both to counteract bank runs and to protect bank creditors.

Use of money multiplier

The use of the money multiplier as a tool of monetary policy is declining, as the money multiplier has changed over time and can usually not be directly influenced by central banks: privately owned banks may have different target levels of liquidity and may not be able to control directly the level of deposits attracted or feasible lending opportunities.^[21]

Liquidity and capital management for a bank

Main articles: Capital requirement and Market liquidity

To avoid defaulting on its obligations, the bank must maintain a minimal reserve ratio that it fixes in accordance with, notably, regulations and its liabilities. In practice this means that the bank sets a reserve ratio target and responds when the actual ratio falls below the target. Such response can be, for instance:

1. Selling or redeeming other assets, or securitization of illiquid assets,
2. Restricting investment in new loans,
3. Borrowing funds (whether repayable on demand or at a fixed maturity),
4. Issuing additional capital instruments, or
5. Reducing dividends.

Because different funding options have different costs, and differ in reliability, banks maintain a stock of low cost and reliable sources of liquidity such as:

1. Demand deposits with other banks
2. High quality marketable debt securities
3. Committed lines of credit with other banks

As with reserves, other sources of liquidity are managed with targets.

The ability of the bank to borrow money reliably and economically is crucial, which is why confidence in the bank's creditworthiness is important to its liquidity. This means that the bank needs to maintain adequate capitalisation and to effectively control its exposures to risk in order to continue its operations. If creditors doubt the bank's assets are worth more than its liabilities, all demand creditors have an incentive to demand payment immediately, a situation known as a run on the bank.

Contemporary bank management methods for liquidity are based on maturity analysis of all the bank's assets and liabilities (off balance sheet exposures may also be included). Assets and liabilities are put into residual contractual maturity buckets such as 'on demand', 'less than 1 month', '2-3 months' etc. These residual contractual maturities may be adjusted to account for expected counter party behaviour such as early loan repayments due to borrowers refinancing and expected renewals of term deposits to give forecast cash flows. This analysis highlights any large future net outflows of cash and enables the bank to respond before they occur. Scenario analysis may also be conducted, depicting scenarios including stress scenarios such as a bank-specific crisis.

Risk and prudential regulation

In a fractional-reserve banking system, in the event of a bank run, the demand depositors and note holders would attempt to withdraw more money than the bank has in reserves, causing the bank to suffer a liquidity crisis and, ultimately, to perhaps default. In the event of a default, the bank would need to liquidate assets and the creditors of the bank would suffer a loss if the proceeds were insufficient to pay its liabilities. Since public deposits are payable on-demand, liquidation may require selling assets quickly and potentially in large enough quantities to affect the price of those assets. An otherwise solvent bank (whose assets are worth more than its liabilities) may be made insolvent by a bank run. This problem potentially exists for any corporation with debt or liabilities, but is more critical for banks as they rely upon public deposits (which may be redeemable upon demand).

Although an initial analysis of a bank run and default points to the bank's inability to liquidate or sell assets (i.e. because the fraction of assets not held in the form of liquid reserves are held in less liquid investments such as loans), a more full analysis indicates that depositors will cause a bank run only when they have a genuine fear of loss of capital, and that banks with a strong risk adjusted capital ratio should be able to liquidate assets and obtain other sources of finance to avoid default. For this reason, fractional-reserve banks have every reason to maintain their liquidity, even at the cost of selling assets at heavy discounts and obtaining finance at high cost, during a bank run (to avoid a total loss for the contributors of the bank's capital, the shareholders).

Many governments have enforced or established deposit insurance systems in order to protect depositors from the event of bank defaults and to help maintain public confidence in the fractional-reserve system.

Example of a bank balance sheet and financial ratios

An example of fractional reserve banking, and the calculation of the reserve ratio is shown in the balance sheet below:

Example 2: ANZ National Bank Limited Balance Sheet as at 30 September 2007[citation needed]
ASSETS	NZ$m	LIABILITIES	NZ$m
Cash	201	Demand Deposits	25482
Balance with Central Bank	2809	Term Deposits and other borrowings	35231
Other Liquid Assets	1797	Due to Other Financial Institutions	3170
Due from other Financial Institutions	3563	Derivative financial instruments	4924
Trading Securities	1887	Payables and other liabilities	1351
Derivative financial instruments	4771	Provisions	165
Available for sale assets	48	Bonds and Notes	14607
Net loans and advances	87878	Related Party Funding	2775
Shares in controlled entities	206	[subordinated] Loan Capital	2062
Current Tax Assets	112	Total Liabilities	99084
Other assets	1045	Share Capital	5943
Deferred Tax Assets	11	[revaluation] Reserves	83
Premises and Equipment	232	Retained profits	2667
Goodwill and other intangibles	3297	Total Equity	8703
Total Assets	107787	Total Liabilities plus Net Worth	107787

In this example the (legal tender) cash held by the bank is $201m and the demand liabilities of the bank are $25482m, for a (legal tender) cash reserve ratio of 0.79%.

Other financial ratios

The key financial ratio used to analyse fractional-reserve banks is the cash reserve ratio, which is the ratio of cash reserves to demand deposits and notes. However, other important financial ratios are also used to analyse the bank's liquidity, financial strength, profitability etc.

For example the ANZ National Bank Limited balance sheet above gives the following financial ratios:

1. The (legal tender) cash reserve ratio is $201m/$25482m, i.e. 0.79%.
2. The central bank notes/balances reserve ratio is $3010m/$25482m, i.e. 11.81%.
3. The liquid assets reserve ratio is ($201m+$2809m+$1797m)/$25482m, i.e. 18.86%.
4. The equity capital ratio is $8703m/107787m, i.e. 8.07%.
5. The tangible equity ratio is ($8703m-$3297m)/107787m, i.e. 5.02%
6. The total capital ratio is ($8703m+$2062m)/$107787m, i.e. 9.99%.

Clearly, then, it is very important how the term 'reserves' is defined for calculating the reserve ratio, and different definitions give different results. Other important financial ratios may require analysis of disclosures in other parts of the bank's financial statements. In particular, for liquidity risk, disclosures are incorporated into a note to the financial statements that provides maturity analysis of the bank's assets and liabilities and an explanation of how the bank manages its liquidity.

How the example bank manages its liquidity

The ANZ National Bank Limited explains its methods as:^{[citation needed]}

“

Liquidity risk is the risk that the Banking Group will encounter difficulties in meeting commitments associated with its financial liabilities, e.g. overnight deposits, current accounts, and maturing deposits; and future commitments e.g. loan draw-downs and guarantees. The Banking Group manages its exposure to liquidity risk by maintaining sufficient liquid funds to meet its commitments based on historical and forecast cash flow requirements.

”

“

The following maturity analysis of assets and liabilities has been prepared on the basis of the remaining period to contractual maturity as at the balance date. The majority of longer term loans and advances are housing loans, which are likely to be repaid earlier than their contractual terms. Deposits include substantial customer deposits that are repayable on demand. However, historical experience has shown such balances provide a stable source of long term funding for the Banking Group. When managing liquidity risks, the Banking Group adjusts this contractual profile for expected customer behaviour.

”

Example 2: ANZ National Bank Limited Maturity Analysis of Assets and Liabilities as at 30 September 2007[citation needed]
	Total carrying value	Less than 3 months	3-12 months	1-5 years	Beyond 5 years	No Specified Maturity
Assets
Liquid Assets	4807	4807
Due from other financial institutions	3563	2650	440	187	286
Derivative Financial Instruments	4711					4711
Assets available for sale	48	33	1	13		1
Net loans and advances	87878	9276	9906	24142	44905
Other Assets	4903	970	179			3754
Total Assets	107787	18394	10922	25013	45343	8115
Liabilities
Due to other financial institutions	3170	2356	405	32	377
Deposits and other borrowings	70030	53059	14726	2245
Derivative financial instruments	4932					4932
Other liabilities	1516	1315	96	32	60	13
Bonds and notes	14607	672	4341	9594
Related party funding	2275	2275
Loan capital	2062		100	1653	309
Total liabilities	99084	60177	19668	13556	746	4937
Net liquidity gap	8703	(41783)	(8746)	11457	44597	3178
Net liquidity gap - cumulative	8703	(41783)	(50529)	(39072)	5525	8703

Criticism

Main article: Criticism of fractional-reserve banking

Although fractional-reserve banking is near universal, it is not without criticism. The primary criticisms relate to the potential fragility of bank liquidity in a fractional reserve banking environment, the financial risk of bank runs that depositors bear when depositing money with banks, and the impact that demand deposits have on the stock of money, and on inflation (that is, the implicit debasement of the currency and its associated impact on the exchange rate). An alternative to fractional reserve banking is making the practice illegal and classifying the practice as a form of embezzlement, only permitting full-reserve banking.^[22] With full-reserve banking, some monetary reformers as such as Stephen Zarlenga of the American Monetary Institute, support the concurrent issuance of debt-free fiat currency from the Treasury, while others such as Congressman Ron Paul and the Ludwig von Mises Institute call for a commodity currency such as was possible under the Gold Standard.^[23][24][25]

Exacerbation of the business cycle

Main article: Austrian Business Cycle Theory

Austrian School economists claim that fractional-reserve banking, by expanding the money supply, will lower the interest rates compared to a full-reserve banking system. They argue that this will affect the role of the interest rate as the price of investment capital, guiding investment decisions. In their view, the natural (free of government influence) interest rate reflects the actual time preference of lenders and borrowers. Government control of the money supply through central banks and regulations allowing fractional-reserve banking disturbs this equilibrium such that the interest rate no longer reflects the real supply of and demand for investment capital. Austrian School economists conclude that, if the interest rate is artificially low, then the demand for loans will be higher than the actual supply of willing lenders, and if the interest rate is artificially high, the opposite situation will occur. This misinformation leads investors to misallocate capital, borrowing and investing either too much or too little in long-term projects. Periodic recessions, then, are seen as necessary "corrections" following periods of fiat credit expansion, when unprofitable investments are liquidated, freeing capital for new investment. One of the proponents of aspects of the business cycle theory, Friedrich von Hayek, was awarded the Nobel Prize in Economics,^[26] but the theory is not generally accepted as an adequate refutation of Keynesian economic theory.^[27] A few Austrian School economists, such as Pascal Salin, also suggest that a full-reserve banking system should not be enforced and rather advocate the abolition of central banking and having free banking replace the current system.

Risk

Main article: Full-reserve banking

In a fractional-reserve banking system, in the event of a bank run, the demand depositors and note holders would attempt to withdraw more money than the bank has in reserves, causing the bank to suffer a liquidity crisis and, ultimately, to perhaps default. In the event of a default, the bank would need to liquidate assets and the creditors of the bank would suffer a loss if the proceeds were insufficient to pay its liabilities. Since public deposits are payable on-demand, liquidation may require selling assets quickly and potentially in large enough quantities to affect the price of those assets. An otherwise solvent bank (whose assets are worth more than its liabilities) may be made insolvent by a bank run. This problem potentially exists for any corporation with debt or liabilities, but is more critical for banks as they rely upon public deposits (which may be redeemable upon demand).

Although an initial analysis of a bank run and default points to the bank's inability to liquidate or sell assets (i.e. because the fraction of assets not held in the form of liquid reserves are held in less liquid investments such as loans), a more full analysis indicates that depositors will cause a bank run only when they have a genuine fear of loss of capital, and that banks with a strong risk adjusted capital ratio should be able to liquidate assets and obtain other sources of finance to avoid default. For this reason, fractional-reserve banks have every reason to maintain their liquidity, even at the cost of selling assets at heavy discounts and obtaining finance at high cost, during a bank run (to avoid a total loss for the contributors of the bank's capital, the shareholders).

Many governments have enforced or established deposit insurance systems in order to protect depositors from the event of bank defaults and to help maintain public confidence in the fractional-reserve system.

Responses to the problem of financial risk described above include:

1. Proponents of prudential regulation, such as minimum capital ratios, minimum reserve ratios, central bank or other regulatory supervision, and compulsory note and deposit insurance, (see Controls on Fractional-Reserve Banking below);
2. Proponents of free banking, who believe that banking should be open to free entry and competition, and that the self-interest of debtors, creditors and shareholders should result in effective risk management; and,
3. Withdrawal restrictions: some bank accounts may place a limit on daily cash withdrawals and may require a notice period for very large withdrawals. Banking laws in some countries may allow restrictions to be placed on withdrawals under certain circumstances, although these restrictions may rarely, if ever, be used;
4. Opponents of fractional reserve banking who insist that notes and demand deposits be 100% reserved.

Effects of an increased money supply

Fractional reserve banking involves the issuance and creation of commercial bank money, which increases the money supply on an exponential basis. According to the quantity theory of money, this increase in the money supply leads to more money "chasing" the same amount of goods, which leads to inflation.^[28] Some monetarists and Austrian economists believe that the exchange rate or purchasing power of the monetary unit is governed by the quantity of money, including demand deposits and notes, and therefore view fractional reserve banking as the main cause of inflation.^[29]

Most schools of economics recognize the link between money supply and inflation; many mainstream economists, however, consider the issue of money through the banking system as a mechanism of monetary transmission, which a central bank can influence indirectly by raising or lowering interest rates (although banking regulations may also be adjusted to influence the money supply, depending on the circumstances).

Quantity theorists may either be hostile to fractional reserve banking or supportive of minimum reserve ratios and other government controls on the quantity of money created by commercial banks. Some support a gold standard or silver standard to restrain "unfettered", "speculative" fractional-reserve banking activities.^[30][31][32]

The process with which commercial banks practice fractional-reserve banking is explained at deposit creation multiplier.