What Is Fractional Reserve Banking & How Does It Work?

Fractional reserve banking underpins the modern global financial system, allowing for widespread credit availability and supporting economic activity. This fundamental practice enables financial institutions to manage deposits and facilitate lending, playing a significant role in how money circulates within an economy.

Fundamentals of Fractional Reserve Banking

Fractional reserve banking is a system where banks accept deposits from the public but are required to hold only a fraction of these deposits as reserves. The remaining portion of the deposits is then available for lending to other customers.

Reserves are typically held as cash in the bank’s vault or as balances in the bank’s account at the central bank. Deposits represent the funds customers place into their bank accounts, such as checking or savings accounts. Loans are the credit extended by banks to borrowers, made possible by the portion of deposits not held in reserve. This system ensures banks maintain sufficient liquidity to meet routine withdrawal demands while simultaneously deploying capital for economic growth.

Historically, a “reserve requirement” mandated the minimum percentage of deposits that banks had to hold in reserve. While the concept of reserves remains central to banking operations, the Federal Reserve reduced the reserve requirement ratio for all depository institutions to zero percent in March 2020. Despite this change, banks still hold reserves for operational purposes like clearing payments and maintaining liquidity.

Commercial Banks and Their Operations

Commercial banks operate by accepting deposits from individuals and businesses, which form the primary basis for their lending activities. When a customer deposits money, the bank records this as a liability. This deposited money then becomes a source of funds the bank can use to generate revenue.

Banks manage these funds by retaining a portion in reserves and lending out the remainder. Lending is a core function for banks, generating interest income that contributes significantly to their profitability. Although the mandated reserve requirement is currently zero, banks still manage their reserve levels to ensure they can meet customer withdrawals and other financial obligations.

The process of lending by commercial banks directly contributes to their business model, as the interest charged on loans provides a return on the funds they deploy. This system allows banks to act as financial intermediaries, connecting savers with borrowers. By facilitating these transactions, banks support various economic activities.

The Central Bank’s Role

The central bank, such as the Federal Reserve in the United States, plays a supervisory and influential role within the fractional reserve banking system. It is responsible for maintaining financial stability and implementing monetary policy.

While the reserve requirement is now zero, the central bank influences the banking system through other means. Key tools include adjusting interest rates, such as the federal funds rate and the interest paid on reserves held by commercial banks. The central bank also conducts open market operations, which involve buying or selling government securities to inject or withdraw money from the banking system, affecting commercial banks’ reserves and their lending. By utilizing these policy instruments, the central bank aims to manage the money supply, control inflation, and promote economic growth.

How Money is Created

Within a fractional reserve banking system, money creation occurs primarily through the process of commercial bank lending, often referred to as the “money multiplier effect.” When a bank issues a loan, it typically does not disburse physical cash. Instead, it creates a new deposit in the borrower’s account, effectively generating new money in the economy.

This newly created deposit can then be spent by the borrower and subsequently redeposited into another bank. The receiving bank, in turn, can lend out a portion of this new deposit, continuing the cycle. Each successive loan and redeposit further expands the money supply beyond the initial deposit.

For example, if an initial deposit of $1,000 is made into Bank A, and Bank A lends out $900, that $900 becomes a new deposit in Bank B when the borrower spends it. Bank B can then lend out a portion of that $900, creating another new deposit, and so on. This cyclical process demonstrates how an initial sum expands the total money supply through credit creation. The actual money creation process is dynamic and influenced by banks’ willingness to lend and borrowers’ demand for credit, rather than being strictly limited by reserves.