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News Link • Federal Reserve

Fractional Reserves and the Fed

• By Joseph T. Salerno

Chairman Paul and members of the Subcommittee, I am deeply honored to appear before you to testify on the topic of fractional-reserve banking. Thank you for your invitation and attention. In the short time I have: I will give a brief description of fractional-reserve banking; identify the problems it presents in the current institutional setting; and suggest a potential solution.

A bank is simply a business firm that issues claims to a fixed sum of money in receipt for a deposit of ready cash. These claims are cashable on demand and without cost to the depositor. In today's world these claims may take the form of checkable deposits, so called because they can be transferred to a third party by writing out a check payable to the party named on the check. They may also take the form of so-called "savings" deposits with limited or no checking privileges and that require withdrawal in person at one of the bank's branches or at an ATM. In the United States, the cash for which the claim is redeemable are the Federal Reserve Notes—the "dollar bills" that we are all familiar with. These dollar bills are the ultimate cash of the contemporary U.S. monetary system.

Fractional-reserve banking occurs when the bank lends or invests some of its depositors' funds and retains only a fraction of the deposits in cash. This cash is the bank's reserves. Hence the name fractional-reserve banking. All U.S. banks today engage in fractional–reserve banking

 Let me illustrate how fractional-reserve banking works with a simple example. Assume that a bank with deposits of $1 million makes $900,000 of loans and investments. If we ignore for simplicity the capital paid in by its owners, this bank is holding a cash reserve of 10 percent against its deposit liabilities. The deposits constitute the bank's liabilities because the bank is contractually obligated to redeem them on demand. The assets of the bank are its cash reserves and noncash assets. The noncash assets include short-term business loans, credit card loans, mortgage loans, and the securities issued by the U.S. Treasury and foreign financial authorities. These assets are claims to cash payable only in the near or distant future.

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