Fractional Reserve Research Paper

The Role of Cash Reserves in Fractional Reserve Banking

1. Introduction

The essay seeks to explain the function that cash reserves play in the fractional reserve banking system. Two types of banks operate in this banking system, monetary savings banks and private commercial banks, both banks are unique in a sense of their ability to create money. This ability is explained that, these banks keep fraction of their outstanding deposits liabilities as cash in reserves against these deposits in the process of providing loans and spending. The focus of the essay will be on commercial banks, as they have added odd ability of money creation with its own debt. Monetary savings banks use cash only to finance lending in the process of creating money. In contrast to monetary savings banks, commercial banks in addition to using cash, they issue their own deposits (new) for lending and spending. The key function of commercial banks is money creation. Cash reserves are a key to fractional reserve banking system. It is clear that keeping fraction of deposits as cash and using own debt (deposits) for lending and spending calls for a need to commercial banks to keep adequate reserves in cash to facilitate for withdrawals

This paper money is referred to as fiat money; cash is in the form of bank notes and coins. The most striking feature of the paper money is not convertible into anything. In this system private bank deposits (bank money/IOUs – derivative money) are convertible into central bank notes (bank money/ IOUs – definitive money) and functions as cash reserves for commercial banks. But this indicates that debt money is convertible into debt money, UNISA (2017a, p.155) under a fiat money standard, all money is bank money. Which means all money is debt money. How it is that debt money is definitive money, due to it being a legal tender. Gold in the system does not feature