Most modern banking systems are based on which type of reserve system?

Introduction / Context:
Modern banking systems play a central role in money creation and credit expansion. They do this primarily through a mechanism known as fractional reserve banking. Competitive exams often ask which type of reserve system forms the basis of today banking operations because it helps students understand how deposits, loans and reserves are related and why central bank regulation is necessary.

Given Data / Assumptions:

• The question refers to banking systems in most contemporary economies.
• Reserve requirements are generally less than one hundred percent of deposits.
• Banks accept deposits and make loans based on those deposits.
• Different options mention commodity money, full reserves, fractional reserves and digital currencies.

Concept / Approach:
In fractional reserve banking, commercial banks are required to keep only a fraction of their deposit liabilities as reserves in the form of cash in vault or balances with the central bank. The remainder can be lent out or invested. When banks make loans, new deposits are created in the system, which expands the money supply. This is different from a full reserve system where all deposits must be backed one hundred percent by reserves, which is not how most modern systems operate. Therefore, the correct option must explicitly refer to fractional reserve banking and the idea that only a portion of deposits is kept as reserves.

Step-by-Step Solution:
Step 1: Recall that customers place money in bank deposits for safety and convenience. Step 2: Recognise that banks do not simply store all deposits but use a large part of them to make loans. Step 3: Note that regulators set minimum reserve ratios such as CRR and SLR, which are less than one hundred percent. Step 4: Understand that this arrangement, where only a fraction is kept as reserves, is called fractional reserve banking. Step 5: Choose the option that states this clearly and reject those that claim full reserves or intrinsic money with no reserves.

Verification / Alternative check:
To verify, consider a simple example. Suppose the reserve requirement is ten percent. If a customer deposits 1,000 in a bank, the bank keeps 100 as reserves and can lend out 900. When the 900 is deposited in the banking system, another bank keeps ninety as reserves and lends out 810, and so on. This process multiplies deposits and loans, showing fractional reserve behaviour. No modern economy widely uses a pure commodity money system with full backing by gold or other metals. This supports the conclusion that most modern systems rely on fractional reserves.

Why Other Options Are Wrong:
Option A is wrong because commodity money with full backing by precious metals is largely historical and no longer the main basis of current systems. Option B describes one hundred percent reserves, which some economists have proposed but which is not generally practised. Option D suggests money of intrinsic value with no reserves, which does not match the way bank deposits and central bank reserves work. Option E overstates the role of digital currencies; while digital forms of money exist, they are usually still part of a fractional reserve framework and not a separate reserve free system.

Common Pitfalls:
Learners sometimes imagine that every unit of bank deposit is physically stored in a vault, which is not the case in fractional reserve banking. Another pitfall is confusing central bank base money with the broader money supply created through bank lending. Some also think that fractional reserves are a new phenomenon linked only to digital banking, though the concept is much older. Understanding fractional reserves is crucial for interpreting discussions about money creation, bank runs and monetary policy in economics and finance.

Final Answer:
Fractional reserve banking where only a portion of deposits is kept as reserves.