What Is Fractional-Reserve Banking?

Definition and Examples of Fractional-Reserve Banking

Open bank vault

 Peter Dazeley / Getty Images

In fractional-reserve banking, the bank is required to hold only a portion of customer deposits on hand, freeing it to lend out the rest of the money. This system is designed to continually stimulate the supply of money available in the economy while keeping enough cash on hand to meet withdrawal requests.

When you deposit funds in a bank, that money is typically available for withdrawal whenever you need it. But that doesn’t mean all of your cash is actually in the bank’s immediate possession. Learn more about how this system works, why it stimulates the economy, and why you can still get your money when you need it.

What Is Fractional-Reserve Banking?

Fractional-reserve banking is the practice of holding a portion of customer deposits in bank reserves and lending out the remainder. Money that would otherwise be idle in bank accounts is circulated, and funds from small deposits are pooled to make loans. This system allows the bank to invest your money and still show the funds sitting in your account. It’s a core tenet of banking and one way to influence the supply of money and grow the economy.

In the United States, the Federal Reserve sets a reserve requirement—a minimum that banks must have set aside. Banks must hold that money as cash in vaults or as deposits with Federal Reserve banks. Until recently, the reserve requirement for financial institutions with more than $124.2 million in liabilities was 10%. In other words, those banks can lend $90 of every $100 their customers deposit. The Federal Reserve made history on March 26, 2020, when it dropped reserve requirements to zero.

If the Federal Reserve wants to influence lending and money supply, one way is to change the reserve requirement. These changes have been relatively rare, but they do happen. For instance, the Fed began paying interest on reserves in 2008 in response to the financial crisis. This gave banks more incentive to hold excess in reserves, and overall reserve funds surged.

How Fractional-Reserve Banking Works

The supply of money grows when banks show money as deposits while simultaneously lending the funds out as loans. When you deposit money into your account, the bank shows 100% of the money in your account balance. But the bank is allowed to lend 90% of your deposit to other customers. So this almost doubles the amount of “money” in the economy.

As an illustration, assume we create a brand-new economy and you add the first $1,000 to the system.

  1. You deposit $1,000 into a bank account. The system now has $1,000.
  2. The bank can lend 90% of your deposit, or $900, to its other customers.
  3. Those customers borrow the full $900, and you still have $1,000 in your account, so the system has $1,900.
  4. Customers spend the $900 they borrowed, and the recipients of that money deposit $900 into their bank.
  5. That bank can lend out 90%, or $810, of the new $900 deposit.
  6. Customers borrow the $810. You still have $1,000 in your account, and the recipients of the first $900 still have that money available in their accounts. So the system now has $2,710 ($1,000 + $900 + $810).
  7. The cycle, known as the money multiplier, continues.

The Danger of Bank Runs

Fractional-reserve banking works because people typically don’t need access to all of their money at the same time. You may have $1,000 available in your account, but it’s unlikely that you’ll withdraw all of it at once. If you do, the reserves from other customer accounts should be enough to cover your withdrawal.

Things break down, however, if everybody in the system withdraws their money at the same time. This is often referred to as a “bank run.” When customers fear that a bank (or the banking system as a whole) is in financial trouble, they flood the bank with withdrawal demands.

If this happens, the money is not there to satisfy the requests, so the bank becomes insolvent. Bank failures during the Great Depression were catastrophic for those who lost their life savings in bank accounts. As a result, the Banking Act of 1933 established the Federal Deposit Insurance Corporation (FDIC), which protects deposits in participating banks up to certain limits.

The FDIC provides a government guarantee that customers will get their money even if a bank’s investments go sour. Credit unions have similar coverage from the National Credit Union Share Insurance Fund.

Alternatives to Fractional-Reserve Banking

Critics have likened fractional-reserve banking to a house of cards. They worry that there’s nothing to back the assets in the system and that the economy may eventually collapse or market participants will lose confidence in the system. These concerns are only amplified now that the Fed has reduced reserve requirements to zero.

The alternative to a fractional-reserve system is a full-reserve banking system in which banks must keep 100% of all deposits on hand at all times. This could apply to all deposits or only those intended for immediate cash needs, such as checking and savings accounts. The more strict the requirement, the less cash is available for lending and circulating in the economy.

One thing is for sure: Without fractional-reserve banking, your relationship with banks would look different. Instead of paying you interest on your deposits, banks might charge you (or charge significantly more) for their services. In the system we’re used to, banks earn revenue by putting your money to work and keeping the difference between what they charge borrowers and what they pay you as the depositor. A full-reserve system would have to find a way to compete with this setup.

Key Takeaways

  • Fractional-reserve banking is a system that allows banks to keep only a portion of customer deposits on hand while lending out the rest.
  • This system allows more money to circulate in the economy.
  • Critics of the system say it creates the danger of a bank run, where there is not enough money to meet withdrawal requests.
  • The Federal Reserve reduced required reserves to zero on March 26, 2020.