Banks need a certain amount of money to operate, when you invest money with them they will lend out or invest that money elsewhere. They will only maintain a small amount of the money deposited in a reserve, which allows investors to withdraw their money at will. This reserve (Capital Requirement here) is determined by central bank decisions and is used as a macroeconomic control mechanism.
The greater the capital requirement the less money is allowed into the economy and conversely the smaller the capital requirement the more money is introduced into the economy. However if the capital requirement is too small there may not be enough money to cover the withdrawals of the investors. If that happens, it could stop the investors from gaining access to their funds or start a run on the bank.
Banks often borrow money from other banks to cover greater than expected withdrawals to prevent shortages in capital reserves that could result in a collapse or run. The Central Bank acts as the lender of last resort if the bank cannot get another bank to lend to them, if this scenario occurs, which it has done many times in the past.
Fractional Reserve Banking and the Central Banks.
This method of banking is seen as being more efficient as it enables money to be used in the economy to maximise output, rather than investments sitting in a safe where they are not reinvested to create production and employment. It is called fractional reserve banking because only a fraction of the investment is held back by the bank in the capital requirement to cover investor's withdrawals.
The monetarist perspective of economics, which has dominated the Western world over the last thirty years, endeavours to maintain prices by sustaining money supply levels through banking mechanisms such as capital requirement manipulation. The operation of the banks and stability of investor's savings have become secondary to macroeconomic targets set by the central banks.
This priority of money supply targets has led to low levels of capital reserves to cover the withdrawals of investors, nearly leading to a collapse of Northern Rock during the peak of the financial crisis. The situation became so dire that government intervention in the form of state backing and central control took place at Northern Rock and Royal Bank of Scotland.
The Expansion of Credit.
The use of the interest rate, which is set by increasing or decreasing the availability of debt often in the form of Open Market Operations, has led to a huge private sector deficit. The biggest and most far reaching problem created by the central banks in regards to private sector banking is the expansion of credit, not so much from Open Market Operations but through increasing the amount that borrowers can be lent or the duration the debt can be borrowed.
Open Market Operations, Capital Requirement manipulation and other central bank activities may have increased the availability or supply of debt however they did not increase the demand. To increase the amount of borrowing the lending requirements were eased to enable a greater sum to be expended at the time of borrowing, with the expectation that it would be paid back at a later date.
The period of time people could borrow money for against their earnings at the time the money was lent was extended. For example it would be possible for someone who earned say £40,000 p.a. to borrow an amount that equated two and a half years their salary in the past allowing them to receive £100,000 in funds at the time of borrowing.
Recent bank operations, which were allowed and often encouraged by central banks, enabled someone who earned say £40,000 p.a. to borrow an amount that equated to five or even seven years their salary, £200,000 - £280,000 as opposed to £100,000 before the credit expansion. This increased allowance in borrowing inflated the money supply in the short term but it has come at the cost of the long term economy, when the lent funds have to be paid back in the future the money supply will shrink.
The Consequences of Central Bank Actions.
Now remember how the banking system is set up with only a fraction of the money lent to the banks being held to cover withdrawals. Due to the central bank's intervention in the private banks capital requirements to 'hit inflation targets' the amount held to enable withdrawals has fallen. In addition to that the amount of money in circulation has diminished due to the repayment of the expanded credit over the last thirty years (and in particular the last fifteen years).
The functioning of the banking system has been detrimentally effected by the operations of the central bank. The ability of borrowers to repay the existing debt has diminished due to the shortage of money in the economy, as a result of debt repayment, which was created by the credit expansion initiated by central banks during the boom period that occurred over the last fifteen years.
The ability of banks to cover the withdrawals investors desire has also deteriorated partly from the reduced income of private banks, due to bad debt, and partly from central bank actions to lower capital requirements to hit inflation targets. Central banks concentrated on money supply and inflation targets as a priority over the functioning of the banking system in entirety.
As a result of central bank intervention to meet macroeconomic targets the operations of the private banking system are under fire. The question is will it come at a bigger cost in the long term when the full consequences of the extended lending seen during the boom period comes to fruition. As both private and public sector debts are at record real term levels it is just a matter of time before we will find out.