What Is Fractional Reserve Banking and How Does It Work?

Fractional reserve banking is the standard system used by financial institutions across the globe. This widespread practice allows banks to manage deposits and facilitate lending activities that underpin much of modern commerce. It represents a fundamental aspect of how money circulates within an economy.

Understanding Fractional Reserve Banking

Fractional reserve banking operates on the principle that banks hold only a portion of customer deposits as reserves, making the remainder available for lending. The concept’s origins can be traced back to historical practices, such as those of goldsmiths who, after storing precious metals, realized they could lend out a portion of these deposits. They observed that not all depositors would seek to withdraw their assets simultaneously, allowing for the profitable use of excess holdings. This historical development laid the groundwork for the modern banking structure where deposits are not entirely held in physical form.

The Mechanics of Fractional Reserve Banking

The process of fractional reserve banking begins when a customer deposits funds into a bank account. For instance, if a customer deposits $1,000, the bank retains a fraction as a reserve and lends out the remainder. This loan is then deposited into another bank, restarting the cycle.

When the borrowed money is deposited, the second bank also keeps a fraction as a reserve and lends out the rest. This sequential lending and redepositing across the banking system allows for the creation of new money in the form of credit. This is known as the “money multiplier” effect, where an initial deposit leads to a larger expansion of the overall money supply. For example, if a bank receives a $1,000 deposit and keeps 10% ($100) as a reserve, it can lend out $900. When that $900 is deposited elsewhere, the next bank holds $90 and lends out $810, continuing the expansion.

Reserves and the Central Bank’s Role

Reserves within the banking system consist of cash held in a bank’s vault or balances maintained in its account at the central bank. These reserves are categorized into required reserves and excess reserves. Required reserves are the minimum amount of funds that a bank must hold, historically a percentage of its deposits. Excess reserves are any funds a bank holds above this mandated minimum.

Historically, the Federal Reserve set specific reserve requirement ratios for depository institutions. Before March 2020, these ratios varied. However, effective March 26, 2020, the Federal Reserve reduced the reserve requirement ratio for all depository institutions to zero percent.

Despite this change, banks still hold reserves voluntarily for operational purposes, such as processing payments and managing liquidity. The central bank also functions as a “lender of last resort,” providing emergency liquidity to banks facing financial stress to prevent widespread instability or bank runs. This role ensures that banks can meet unexpected withdrawal demands, thereby maintaining confidence in the financial system.

Economic Impact of Fractional Reserve Banking

This system allows banks to extend loans to individuals and businesses, expanding the money supply beyond physical currency. The availability of credit supports various economic activities, from consumer purchases to business investments and expansions. This lending directly contributes to economic growth by providing capital necessary for increased production, job creation, and overall market activity.

The system also plays a part in how interest rates are managed by central banks. While reserve requirements are currently at zero in the U.S., the central bank still influences lending and interest rates through other monetary policy tools. By affecting the amount of money available for lending, fractional reserve banking indirectly impacts the cost of borrowing, which can stimulate or temper economic demand. The banking system, through its lending practices, influences the broader financial environment and supports economic stability.