Banking Basics: Understanding Fractional Reserve Banking and FDIC Insurance
The past few decades have seen several major financial crises that have profoundly impacted the global economy. In the United States, these incidents included the savings and loan crisis of the 1980s, the banking crisis of the early 1990s, the subprime mortgage crisis of 2007-2010, and recently the implosion of Silicon Valley Bank.
These events raised important questions about the banking system’s stability and safety, highlighting the need for greater understanding and transparency in the world of finance. In particular, fractional reserve banking, which allows banks to hold only a fraction of the deposits they receive as reserves, has come under scrutiny as a potential source of instability.
In this post, we explore the basics of banking, including the types of banks, how deposits and withdrawals work, and the role of fractional reserve banking in the financial system. We also discuss the importance of FDIC insurance in protecting depositors’ funds and offer tips for choosing a safe and reliable bank.
Types of Banks
Banks come in many different shapes and sizes, so understanding their differences is important. Here are three types of banks you may encounter:
Commercial banks: These are the most common type of bank (JPM, Wells Fargo, Citi, etc.) and offer a wide range of services to individuals, businesses, and organizations. Commercial banks typically have extensive networks of branches and ATMs, and may offer services such as checking and savings accounts, loans, credit cards, and wealth management services.
Savings and loan associations (S&Ls): S&Ls are similar to commercial banks but focus more on providing mortgage loans and other types of real estate financing. They may also offer savings accounts, checking accounts, and other banking services.
Credit unions: Credit unions are not-for-profit financial institutions owned and operated by their members. They typically offer similar services to commercial banks and S&Ls, but they may have lower fees and offer higher interest rates on deposits. However, credit unions may have more limited networks of branches and ATMs compared with larger banks.
It’s important to choose the right type of bank based on your needs and preferences. For example, a commercial bank may be the best choice if you’re looking for a wide range of services and a large network of branches and ATMs. If you’re primarily interested in real estate financing, an S&L may be a good option. And if you’re looking for a not-for-profit institution that offers low fees and higher interest rates, a credit union may be the way to go.
Depositing Money at a Bank
Depositing and withdrawing money from a bank account is fundamental to banking. When you make a deposit, you’re putting money into your account, while a withdrawal means taking money out of your account.
When you make a deposit, the bank holds on to your money until you’re ready to make a withdrawal or use the funds to make purchases. However, banks also use the money that clients deposit to make loans to other clients or invest in other assets. This is where the concept of fractional reserve banking comes in.
Fractional reserve banking is a system that requires banks to hold only a fraction of the deposits they receive as reserves while using the rest to make loans or investments. For example, if a bank has a reserve requirement of 10% and receives $100 in deposits, it would hold $10 as reserves and use the remaining $90 to make loans or investments.
Here’s another illustration: Imagine having a jar of candy you share with your friends. Every time a friend puts a piece of candy into the pot, you set aside a fraction of the candy as your reserve and use the rest to give to other friends asking for candy.
Now imagine that your friends start bringing more candy to share with the group, and you decide to keep less and less candy as your reserve. Eventually, you’re holding a tiny fraction of the candy as your reserve and using the rest to give to your friends.
This is a bit like how fractional reserve banking works. Banks take in client deposits and keep a small portion of the money as reserves, while using the rest to make loans or investments. Just as with the candy jar, banks’ reserves can change over time depending on how much money they’re taking in and lending out.
This system allows banks to create money and increase the money supply, which can stimulate economic growth. However, it also carries some risk for banks and the broader financial system. If too many clients withdraw their deposits at once, a bank may not have enough reserves to meet the demand, potentially leading to a bank run like what happened to Silicon Valley Bank.
FDIC Insurance
Fractional reserve banking, while promoting economic growth, carries some level of risk for banks and their clients, which is why the Federal Deposit Insurance Corporation (FDIC) provides insurance for deposits held in participating banks.
One of the most important considerations when choosing a bank is the safety of your deposits. Fortunately, the FDIC provides insurance for deposits held in participating banks, which helps protect clients’ funds if the bank fails.
FDIC insurance covers deposits in checking accounts, savings accounts, money market accounts, and certificates of deposit (CDs) up to a certain limit. As of 2023, the standard deposit insurance amount is $250,000 per depositor, per ownership category, per insured bank.
FDIC insurance is funded by premiums paid by participating banks, not by taxpayers. This means that even if a bank fails, clients’ deposits are still protected up to the insured limit. The FDIC will typically work to resolve the situation by selling the bank’s assets or arranging for another bank to take over its deposits.
One real-life example of the importance of FDIC insurance occurred during the 2008 financial crisis, when Washington Mutual, one of the largest savings and loan associations in the United States, failed. At the time, Washington Mutual had over $300 billion in assets and more than 2,000 branches across the country. However, like many banks during the financial crisis, Washington Mutual made risky loans, ultimately leading to its downfall.
When Washington Mutual failed, the FDIC stepped in to protect depositors’ funds. The FDIC arranged for JPMorgan Chase to acquire the bank’s deposits, ensuring that depositors’ funds were safe and that they could access their accounts without interruption. In total, the FDIC paid out over $12 billion to depositors of Washington Mutual, making it the largest bank failure in U.S. history at the time.
It’s important to note that FDIC insurance covers only deposits and not other types of financial products or investments, such as stocks, bonds, or mutual funds. Additionally, not all banks participate in FDIC insurance, so it’s important to check that your bank is FDIC-insured before opening an account.
When choosing a bank, it’s a good idea to look for one that is FDIC-insured and has a strong reputation for financial stability.
Conclusion
Understanding the basics of banking is a critical first step in building a strong foundation for your finances. By choosing the right type of bank, managing your deposits and withdrawals effectively, and staying informed about the risks and benefits of fractional reserve banking, you can protect your assets and achieve your financial goals.
It’s also important to remember that financial crises happen and that the banking system is not immune to risk. However, by working with a trusted financial advisor, doing your due diligence when choosing a bank, and staying informed about the latest developments in finance, you can minimize your risk and make smart financial decisions.
At the end of the day, the world of finance can be complex and intimidating, but with the right knowledge and resources, you can navigate it successfully and achieve your financial goals. Whether you’re saving for a down payment on a home, planning for retirement, or just looking to build your wealth, understanding the basics of banking is a critical first step on your journey to financial success.
This material was generated using artificial intelligence (ChatGPT) and edited by RPA Wealth Management and Kaleido Inc. from information derived from sources believed to be accurate. This information should not be construed as investment, tax, or legal advice.