Which of the following is a defining characteristic of a fractional reserve banking system?

• A. Banks must keep 100% of deposits on hand at all times.
• B. Banks are required to keep only a portion of deposits as reserves and can lend out the remainder.
• C. Banks can issue currency without any regulatory oversight.
• D. Banks are prohibited from making loans to customers.

Answer: (B)

Verified step by step guidance

1. Understand the concept of a fractional reserve banking system: In this system, banks are required to keep only a portion of their deposits as reserves, while the remainder can be lent out to borrowers. This is a key feature that distinguishes it from other banking systems.
2. Eliminate incorrect options: Review each option provided in the problem and identify which ones do not align with the definition of a fractional reserve banking system. For example, the option stating that banks must keep 100% of deposits on hand is incorrect because it contradicts the fractional reserve principle.
3. Focus on the correct characteristic: The defining feature of a fractional reserve banking system is that banks are required to hold a fraction of deposits as reserves, not the full amount. This allows them to lend out the remaining portion, facilitating credit creation in the economy.
4. Consider regulatory oversight: Fractional reserve banking systems operate under regulatory frameworks that ensure banks maintain the required reserve ratio. This prevents excessive lending and ensures financial stability.
5. Confirm the correct answer: Based on the analysis, the correct answer is the option stating that banks are required to keep only a portion of deposits as reserves and can lend out the remainder. This aligns with the defining characteristic of a fractional reserve banking system.