fractional reserve banking

Fractional Reserve Banking

Fractional reserve banking is a system in which banks are required to keep only a fraction of their customers’ deposits on hand as reserves, while lending out the rest. In most cases, banks hold a small percentage of total deposits in cash or with a central bank, such as the Federal Reserve in the United States. The remaining funds are used to make loans to other customers, businesses, or governments.

This system is the foundation of modern banking in most countries. Because banks lend out a large portion of the money deposited with them, they are generally not holding a dollar-for-dollar match of all deposits at any given time. The practice is carefully regulated, and banks are typically required to meet minimum reserve requirements set by their central bank or national regulator.

Why it matters

Fractional reserve banking allows money to flow through an economy more efficiently. When a bank lends out deposited funds, those funds typically get spent and redeposited elsewhere, creating a cycle that expands the overall money supply beyond the original deposits. This process, sometimes called the “money multiplier effect,” generally supports economic growth by making credit available to borrowers who need it.

However, the system also carries risks. If a large number of depositors try to withdraw their funds at the same time, a bank may not have enough cash on hand to meet all requests. This situation is known as a “bank run.” To protect consumers, most countries offer deposit insurance programs. In the United States, the FDIC typically insures individual depositor balances up to $250,000 per institution.

Example

Suppose you deposit $1,000 into a savings account at your local bank. With a reserve requirement of 10 percent, the bank is generally required to hold $100 in reserve and can lend out the remaining $900. A borrower takes out that $900 as a personal loan and deposits it at a different bank. That second bank then holds $90 in reserve and lends out $810. This cycle continues, meaning your original $1,000 deposit can support significantly more than $1,000 in total loans across the banking system.

Related terms

• Reserve requirement
• Bank run
• Money multiplier
• Deposit insurance
• Central bank