In a fractional reserve banking system, only a portion of bank deposits are redeemable and guaranteed by real cash on hand. The idea behind this is to release funds for lending, thereby potentially growing the economy.

The process by which banks generate money through fractional reserve banking can be summed up as follows:

1. Initial Deposit: Let’s say a customer deposits $1000 into a bank. The bank keeps a fraction of that deposit in reserve (say 10%, or $100) and lends out the rest ($900).
2. Loan Becomes New Deposit: The $900 loaned out doesn’t disappear; it generally ends up deposited in another bank account, perhaps because it was spent and the recipient of that money deposited it into their own account. Now, that $900 deposit becomes another bank’s liability and asset.
3. Process Repeats: The second bank then keeps a fraction of that $900 deposit in reserve (10%, or $90) and lends out the rest ($810). This process repeats, with each new loan becoming someone else’s new deposit, and each new deposit forming the basis for a new loan.

The initial $1,000 deposit might potentially generate up to $10,000 in new funds through this method (assuming a 10% reserve requirement). This is so that every new loan, which turns into a new deposit, can be re-loaned, with the exception of the portion kept in reserve.

It’s crucial to remember that although this process adds to the economy’s money supply, it doesn’t produce new wealth. Bank-required debts balance the money that is generated.

By enabling banks to use their deposits as leverage to make loans, this system promotes economic activity. It also implies that the bank can run out of reserves and experience a bank run if too many customers try to take their deposits all at once. Because of this, the banking system’s stability is essential and strictly controlled.

Fractional system risks

Despite being the foundation of contemporary banking and finance, fractional reserve banking is not without risk. The following are some of the main dangers connected to this system:

1. Bank Runs: Possibly the most well-known risk. The bank might not have enough reserves on hand to cover these withdrawals if depositors decide to take their money all at once because they no longer trust the bank’s stability. This might result in a bank run, which would bring down the bank.
2. Credit Risk: Banks provide loans to individuals, companies, and other organizations. There’s always a chance that the borrower would miss payments on the loan, which could cost the bank money. Widespread defaults could jeopardize the bank’s stability.
3. Interest Rate Risk: Banks borrow short-term (from depositors) and lend long-term. If interest rates rise sharply, the cost of borrowing could exceed the return from lending, leading to losses.
4. Liquidity Risk: A specific amount of cash must be kept on hand by banks to cover daily expenses. A bank can find itself unable to meet its short-term cash needs if it makes excessive investments in non-liquid assets (such as long-term loans).
5. Systemic Risk: The financial system is interrelated, so when one bank fails, it may have a cascading impact that affects other banks in the system. A systemic crisis resulting from this might impact the whole financial sector as well as the overall economy.
6. Inflation Risk: Inflation may result from banks creating an excessive amount of money through loan activities. This could weaken the purchasing power of money and cause economic instability if it is not handled correctly.

Capital adequacy ratio

Capital adequacy ratios (CARs) are a measure of a bank’s capital. They are used to protect depositors and promote the stability and efficiency of financial systems around the world. Two types of capital are measured: tier one capital, which can absorb losses without a bank being required to cease trading, and tier two capital, which can absorb losses in the event of a winding-up and so provides a lesser degree of protection to depositors.

Here’s a simplified explanation of how banks calculate capital adequacy ratios:

1. Tier 1 Capital: This is the core capital of the bank and includes ordinary share capital, disclosed reserves, retained earnings, and other instruments that fulfill certain criteria.
2. Tier 2 Capital: This is supplementary capital and includes undisclosed reserves, revaluation reserves, general loan-loss reserves, hybrid (debt/equity) capital instruments, and subordinated debt.
3. Risk-Weighted Assets (RWA): These are the total of all assets held by the bank which are weighted by credit risk according to a formula determined by the Regulator (most often the country’s central bank). Different types of assets (e.g., loans, derivatives, and investments) have different risk weights associated with them.

The two key capital adequacy ratios are:

• Tier 1 Capital to Risk-Weighted Assets (T1C/RWA): This ratio is calculated as the amount of tier 1 capital divided by the total of risk-weighted assets. The higher the ratio, the more loss-absorbing capital the bank has to cover potential risks.
• Total Capital to Risk-Weighted Assets (TC/RWA): This ratio is calculated as the total capital (Tier 1 + Tier 2) divided by the total of risk-weighted assets. This ratio provides a more comprehensive view of the bank’s ability to cover potential risks.

Minimum capital adequacy ratios are usually imposed by regulatory bodies to make sure banks can withstand a certain amount of loss before going bankrupt. These ratios must be maintained by banks at all times; failure to do so may result in fines and operational limitations for the bank.