How Does Fractional Reserve Banking Work?

Fractional reserve banking is a fundamental component of modern financial systems. This practice enables banks to utilize a portion of customer deposits for lending and investments, rather than holding all funds in reserve. It plays a significant role in expanding the money supply within an economy, supporting various economic activities. This system balances banks’ need for liquidity with their capacity to generate returns through lending, influencing economic growth and financial stability.

Core Principles of Fractional Reserve Banking

Fractional reserve banking operates on the principle that banks retain only a fraction of deposits, lending out the remainder. “Reserves” are the portion of customer deposits banks hold as physical cash or as balances at the central bank. These reserves serve as a buffer for customer withdrawal demands and daily operational needs.

“Demand deposits” are funds in bank accounts that depositors can withdraw at any time. Checking and savings accounts are common examples, used for everyday transactions. Demand deposits are considered part of a country’s money supply, as they are readily used for payments.

The “reserve ratio” is the percentage of deposits banks are required to hold in reserve. This ratio is typically set by the central bank and dictates the minimum liquid assets a bank must maintain. Banks do not hold 100% of deposits because their business model involves earning interest by lending money. By lending a significant portion, banks generate income and stimulate economic activity by providing capital for borrowers. Any reserves held above the minimum are excess reserves, which banks can also lend. This practice supports the continuous flow of money within the economy, supporting investment and consumption.

The Mechanics of Money Creation

Fractional reserve banking is central to how money is created, expanding the money supply beyond initial deposits. When a bank receives a deposit, it sets aside a portion as reserves and lends out the rest. This lending creates new money, as loaned funds are typically deposited into another bank account, becoming new demand deposits. This process repeats, with each subsequent bank holding a fraction and lending the remainder, leading to a multiplication of the initial deposit.

For example, if a new $1,000 deposit is made into Bank A with a 10% reserve ratio, Bank A holds $100 in reserve. It then has $900 in excess reserves, which it can lend out. When Bank A lends $900 to a borrower, the recipient deposits the $900 into Bank B.

Bank B, now holding a $900 deposit, keeps $90 in reserve and lends the remaining $810. This $810 is then deposited into Bank C, and the cycle continues. Each time a loan is made and redeposited, a new demand deposit is created, increasing the total money supply. The initial $1,000 deposit has, through these successive steps, generated significantly more in total deposits and loans throughout the banking system.

The “money multiplier” quantifies the maximum potential expansion of the money supply from an initial deposit. It is calculated as the reciprocal of the reserve ratio (1 divided by the reserve ratio). For instance, with a 10% reserve ratio (0.10), the money multiplier is 1 / 0.10 = 10. This implies an initial $1,000 deposit could theoretically lead to $10,000 in the money supply. This theoretical maximum assumes banks lend all available excess reserves and all loaned funds are redeposited.

The Role of Central Banks and Reserve Requirements

Central banks, such as the Federal Reserve, oversee and influence the fractional reserve banking system. Their objective is to maintain financial stability and implement monetary policy to achieve economic goals. Historically, a tool for central banks was setting “reserve requirements,” which mandated the minimum percentage of deposits banks had to hold in reserve.

While reserve requirements are fundamental to understanding fractional reserve banking, the Federal Reserve reduced them to zero percent effective March 26, 2020. This means U.S. banks are no longer legally required to hold a specific fraction of deposits as reserves. Despite this, banks still maintain reserves for operational purposes, such as processing transactions and managing liquidity.

Central banks still influence the banking system and money supply through other mechanisms. They affect the amount of reserves available to banks and their ability to lend by influencing interest rates. Adjusting the interest rate paid on reserves held at the central bank can encourage or discourage banks from lending. Central banks also conduct “open market operations,” which involve buying or selling government securities.

When a central bank buys government securities from commercial banks, it pays by crediting the banks’ reserve accounts, increasing their reserves. This provides banks with more funds they can potentially lend, expanding the money supply. Conversely, selling securities reduces bank reserves, limiting their lending capacity. These actions, along with the central bank’s role as a “lender of last resort” providing emergency liquidity, influence money creation within the fractional reserve system.