What Is Fractional Reserve Banking?

Piggy bank bar graph.

PM Images/Getty Images 

When you deposit funds in a bank, that money is typically available for withdrawal whenever you need it. But banks don’t keep all of your cash on hand for safekeeping. Instead, a fractional reserve banking system allows them 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.

What Is Fractional Reserve Banking?

Fractional reserve banking is the practice of holding a portion—or fraction—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.

In the U.S., the Federal Reserve sets a reserve requirement—a minimum that banks must actually have set aside. Banks must hold that money as cash in vaults or as deposits with Federal Reserve Banks. For financial institutions with more than $124.2 million in liabilities, the reserve requirement is currently 10 percent.In other words, those banks can lend out $90 of every $100 their customers deposit.

If the Federal Reserve wants to influence lending and money supply, one way is to change the reserve requirement. While these changes have been rare, 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.

Expanding Money Supply

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 percent of the money in your account balance. But the bank is allowed to lend 90 percent 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 percent 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 percent, 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 plus $900 plus $810).
  7. The cycle, known as the money multiplier, continues.

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. 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 is in financial trouble, they flood the bank with withdrawal demands. 

The money is not there to satisfy the requests, so the bank becomes insolvent. In some cases, bank runs are justified, and sometimes they manifest as a result of panic (causing a bank to fail when it could have stayed afloat).

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 Corp., 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.

A Controversial System

Critics have argued that fractional reserve banking is a house of cards. They worry that there’s nothing to back the assets in the system, and the economy may eventually collapse or market participants will lose confidence in the system.

One thing is for sure: Without fractional reserve banking, your banking relationship would look different. Instead of paying you interest on your deposits, banks might charge you (or charge significantly more) for their services. In fact, 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.

Article Sources

  1. Federal Reserve Bank of Atlanta: Fractional Reserve Banking - An Economist's Perspective

  2. Board of Governors of the Federal Reserve System: Reserve Requirements

  3. Federal Reserve Bank of Richmond: Economic Brief

  4. Financial Sense: Fractional Reserve Banking, Government and Moral Hazard