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This is an approach whereby a bank accepts deposits, makes loans or investments, but is required to hold reserves equal to only a fraction of its deposit liabilities. Reserves are held as currency in the bank, or as balances of the accounts of the concerned commercial bank at the central bank. This is the current form of banking practiced in most of the global economies.
It allows banks to act as financial intermediaries between borrowers and savers, and to provide longer-term loans to borrowers while providing immediate liquidity to depositors this is a financial process termed as maturity transformation. Nevertheless, a bank can experience a bank run if depositors wish to withdraw more funds than the reserves that are held by the bank. To mitigate the risks of bank runs and systemic crises, governments of most economies regulate and oversee commercial banks, provide deposit insurance and act as lender of last resort to commercial banks.
Because banks hold reserves in amounts that are less than the amounts of their deposit liabilities, and because the deposit liabilities are considered money in their own right, fractional-reserve banking permits the supply of money to grow beyond the amount of the underlying base money originally generated by the central bank. In most economies, the central bank or other monetary authority regulates bank credit generation, imposing reserve requirements and capital adequacy ratios. This can slow down the process of money generation that occurs in the commercial banking system, and assist to ensure that banks are solvent and have enough funds to meet demand for withdrawals. Nevertheless, rather than directly controlling the supply of money, central banks usually pursue an interest rate target to adjust the rate of inflation and bank issuance of credit.
Zainabdawa answered the question on July 27, 2018 at 14:30
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