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Central Banks, Commercial Banks, and Fractional Reserve Banking

The financial system is a fundamental pillar of any country’s economy. Within this system, central banks and commercial banks play distinct but interconnected roles, regulating the flow of money and ensuring banking system stability. One key mechanism linking these two types of institutions is the fractional reserve system, which allows commercial banks to operate with only a fraction of customer deposits, facilitating credit creation and monetary expansion.

1.    Central Banks

1.1  What Is a Central Bank?

A central bank is the institution responsible for issuing money, regulating the financial system, and setting a country's or region's monetary policy. Its main objectives are to ensure price stability, promote economic growth, and maintain the stability of the banking system.

1.2  Main Functions of a Central Bank

  • Monetary Policy: The central bank controls the money supply through tools such as:
      • Interest rates: Adjusts the benchmark rate to influence credit costs and consumption.
      • Open market operations (OMO): Buys and sells bonds to regulate money supply.
      • Reserve requirements: Determines the percentage of deposits that commercial banks must keep as reserves.
  • Money Issuance: The central bank is the sole authority responsible for issuing the official currency, ensuring its stability and acceptability in the economy.
  • Financial System Supervision and Regulation: Establishes rules and regulations to prevent banking crises and ensure financial system strength.
  • Lender of Last Resort: When a commercial bank faces liquidity issues, the central bank can lend money to prevent financial system collapse.

Major Central Banks:

·         Federal Reserve (FED) – United States

·         European Central Bank (ECB) – Eurozone

·         Bank of England (BoE) – United Kingdom

·         Bank of Japan (BoJ) – Japan

2.    Commercial Banks

2.1  What Is a Commercial Bank?

A commercial bank is a financial institution that offers services such as deposits, loans, payments, and investment services to individuals and businesses. Its primary objective is to generate profits through financial intermediation.

2.2  Functions of Commercial Banks

  • Deposit Collection: Accepts customer funds in savings accounts, checking accounts, and fixed-term deposits.
  • Loan and Credit Issuance: Uses collected deposits to provide loans to businesses and consumers, generating income through interest.
  • Payment Processing: Facilitates economic transactions through cards, bank transfers, and other payment methods.
  • Investment Services: Some commercial banks offer advisory services and investment products such as mutual funds and pension plans.

2.3  Types of Commercial Banks

  • Retail Banks: Provide financial services to individuals and small businesses.
  • Investment Banks: Specialize in capital markets, mergers, and acquisitions.
  • Universal Banks: Combine retail and investment banking services.

3. Relationship Between Central Banks and Commercial Banks

Central and commercial banks are closely connected through credit regulation, money supply control, and financial system stability.

3.1  Mechanisms of Interaction

  • Liquidity Provision: Commercial banks can borrow from the central bank during liquidity shortages.
  • Regulatory Compliance: Commercial banks must follow central bank regulations regarding minimum reserves and financial transparency.
  • Monetary Policy Influence: The central bank adjusts interest rates, directly impacting the cost of credit and commercial bank profitability.

3.2  Economic Impact

When the central bank lowers interest rates, commercial banks can offer cheaper loans, stimulating investment and consumption. Conversely, when rates rise, borrowing becomes more expensive, reducing spending and controlling inflation.

4.    Fractional Reserve Banking

4.1  What Is Fractional Reserve Banking?

The fractional reserve system is a banking mechanism where commercial banks are only required to keep a fraction of customer deposits as reserves, lending out the remainder.

4.2  How Fractional Reserve Banking Works

  1. A customer deposits $1,000 in a commercial bank.
  2. If the reserve ratio is 10%, the bank must keep $100 as reserves and can lend $900.
  3. The loaned money is deposited into another bank, which also keeps 10% and lends out the rest, creating a money multiplier effect.

4.3  Advantages and Disadvantages

✅ Advantages:

  • Increases liquidity and credit availability.
  • Stimulates economic growth and investment.
  • Enables monetary expansion without printing more money.

❌ Disadvantages:

  • Risk of bank insolvency if too many customers withdraw funds simultaneously (bank runs).
  • Can lead to inflation if excessive credit expansion occurs.

4.4  Financial Crises and Fractional Reserve Banking

During economic crises, confidence in banks may decline, leading to mass withdrawals of deposits. If banks cannot cover these withdrawals, they may collapse, requiring central bank intervention to prevent systemic failure.

5.    Conclusion

Central banks and commercial banks play fundamental roles in the economy by regulating money supply and facilitating financial intermediation. The fractional reserve system enables credit expansion but also introduces risks that require careful regulation. Understanding these dynamics is crucial for evaluating financial system stability and making informed investment decisions.

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