Fractional-reserve banking
In most countries, the central bank (or other monetary policy authority) regulates bank-credit creation, imposing reserve requirements and capital adequacy ratios.
Fractional-reserve banking predates the existence of governmental monetary authorities and originated with bankers' realization that generally not all depositors demand payment at the same time.
These notes gained acceptance as a medium of exchange for commercial transactions and thus became an early form of circulating paper money.
A process was started that altered the role of the goldsmiths from passive guardians of bullion, charging fees for safe storage, to interest-paying and interest-earning banks.
Influencing interest rates are an important part of monetary policy used by central banks to promote macroeconomic stability.
[12] Historically, central banks have occasionally changed reserve requirements discretionarily in order to influence the money supply directly and via that mechanism the interest rate level.
[15] Issuing loan proceeds in the form of paper currency and current coins is considered to be a weakness in internal control.
[16] The money creation process is also 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).
[25] The money multiplier, m, is the inverse of the reserve requirement, R:[26] In countries where the central bank does not impose a reserve requirement, such as the United States, Canada and the United Kingdom, the theoretical money multiplier is undefined, having a denominator of zero.
[20][21] 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 members of the public may choose to hold cash, and there also may be delays or frictions in the lending process.
[28] Government regulations may also limit the money creation process by preventing banks from giving out loans even when the reserve requirements have been fulfilled.
[citation needed] To avoid defaulting on its obligations, the bank must maintain a minimal reserve ratio that it fixes in accordance with regulations and its liabilities.
This means that the bank needs to maintain adequate capitalisation and to effectively control its exposures to risk in order to continue its operations.
These residual contractual maturities may be adjusted to account for expected counterparty 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.
For example, the ANZ National Bank Limited balance sheet above gives the following financial ratios: It is important how the term "reserves" is defined for calculating the reserve ratio, as different definitions give different results.
[41][42] It was proposed as a method of reversing the deflation of the Great Depression, as it would give the central bank (the Federal Reserve in the US) more direct control of the money supply.
[43][page needed] Austrian School economists such as Jesús Huerta de Soto and Murray Rothbard have strongly criticized fractional-reserve banking, calling for it to be outlawed and criminalized.
According to them, not only does money creation cause macroeconomic instability (based on the Austrian Business Cycle Theory), but it is a form of embezzlement or financial fraud, legalized only due to the influence of powerful rich bankers on corrupt governments around the world.
[44][45] US politician Ron Paul has also criticized fractional-reserve banking based on Austrian School arguments.
[46] Adair Turner, former chief financial regulator of the United Kingdom, stated that banks "create credit and money ex nihilo – extending a loan to the borrower and simultaneously crediting the borrower's money account".
