Question

Why is the banking system in the United States referred to as a fractional banking reserve system? What is the role of deposit insurance in a fractional reserve system?

Short answer

In the US banking system, the value of reserves with the central bank is only a fraction of the actual money in supply. Thus it is called a fractional reserve system.

The role of deposit insurance is to safeguard the interests of the depositors during situations when banks go bankrupt.

Step-by-step solution

Reason why US banking system is called Fractional Reserve Banking System

The United States has adopted a Fractional Reserve Banking System, which requires only a fraction of the checkable deposits to be backed by currency reserves in bank vaults or deposits at the Central bank. For example, if the bank has $600 million worth of checkable deposits, and assuming that 10% is the reserve requirement, the bank has to keep $60 million as reserves.

Definition and role of deposit insurance

Deposit insurance is the facility by which depositors can place their money with banks, backed by full faith and credit of the US government. Deposit insurances have two key roles; firstly, they prevent bank runs, where depositors rush to banks to withdraw their money believing rumors that the bank is about to go bankrupt. Secondly, deposit insurance removes the incentive to withdraw one’s deposit by guaranteeing depositors their money back.