Fractional Reserve Banking: What It Is and How It Works

What Is Fractional Reserve Banking?

Fractional reserve banking is a system in which only a fraction of bank deposits are required to be available for withdrawal. Banks only need to keep a specific amount of cash on hand and can create loans from the money you deposit. Fractional reserves work to expand the economy by freeing capital for lending. Today, most economies' financial systems use fractional reserve banking.

Key Takeaways

  • Fractional reserve banking describes a system whereby banks can loan out a certain amount of the deposits that they have on their balance sheets.
  • Banks used to be required to keep a certain amount of the cash depositors placed in their accounts in reserve.
  • All depository institutions are paid a specific interest rate on their reserve balance to encourage holding reserves.

Fractional Reserve Banking

Understanding Fractional Reserve Banking

When you create an account at a bank, in the contract, you agree to allow that bank to use a percentage of your deposits as loans to other bank customers. This doesn't mean you don't have access to the money you deposited; it only means that if you want to remove more than the percentage a bank keeps on hand, such as the entire balance, from the account, the bank will need to access funds from somewhere else to give you your balance.

When you deposit money in your savings account, your bank can use an amount specified as capital to fund loans and pay you for using your money. For instance, say you deposited $2,000 in a savings account. Savings accounts pay interest—generally between 0.5% and 2%—so you receive an interest payment on your money, and the bank can use part of it in a loan. In turn, the bank might want to access 80% of your money to use as loans to other customers.

You receive interest as an incentive for keeping money in an account the bank can use to create loans.

The Federal Reserve sets interest rates. They are based on economic circumstances and how it decides it can best meet its dual mandate of maximum employment and price stability. If a bank needs capital to fund loans, withdrawals, pay debts, or meet other obligations, it can borrow from other banks and pay them interest. As a last resort, the Federal Reserve maintains a service called the discount window, where it lends money to banks at a higher interest rate than they charge between themselves. This encourages banks to seek funds from each other rather than the Fed.

Interest is charged between financial institutions based on a range set by the Federal Reserve Board of Governors called the federal reserve target rate range. The average interest rate banks charge each other is referred to as the effective Federal Funds Rate.

Fractional Reserve Banking Process

The fractional reserve banking process creates money that is inserted into the economy. When you deposit that $2,000, your bank might lend 10% of it to other customers, along with 10% from five other customers' accounts. This creates a loan of $1,000 for the customer needing a loan.

Your balance still reflects $2,000, and the customers that the bank borrowed from also see their balances remain unchanged. If all five customers have account balances of $2,000, it will look something like this:

  • You and five other customers have $2,000 in savings.
  • If the bank can use 90% of its deposits for loans, the available capital is $9,000 (90% of $10,000).
  • The bank borrows 10% from each of the five accounts, totaling $1,000.
  • There is still a balance of $2,000 in each account ($10,000 total between the five accounts).
  • The bank essentially created $1,000 and lent it to the borrower.
  • You receive interest payments on your $2,000, and the bank receives interest at a higher rate from the borrower to pay your interest and profit from the service.

History of Fractional Reserve Banking

Fractional reserve banking supposedly has its roots in an era when gold and silver were traded. Goldsmiths would issue promissory notes, which were later used as a means of exchange. The smiths used the deposited gold to issue loans with interest, and fractional banking was born.

In the U.S., the National Bank Act was passed in 1863 to require banks to keep reserves on hand to protect depositor funds from being used in risky investments. In 1913 the Federal Reserve Act created the system of Federal Reserve banks we now know collectively as the Federal Reserve System. Banks were required to keep reserve balances with the Federal Reserve Banks.

Reserve requirements for banks under the Federal Reserve Act were set at 13%, 10%, and 7% (depending on the type of bank) in 1917. In the 1950s and '60s, the Fed had set the reserve ratio as high as 17.5% for certain banks, and it remained between 8% to 10% throughout much of the 1970s through the 2010s.

During this period, banks with fewer than $16.3 million in assets were not required to hold reserves. However, banks with fewer than $124.2 million in assets but more than $16.3 million had to have a reserve size of 3%, and those banks with more than $124.2 million in assets had a 10% reserve requirement.

On March 26, 2020, the 10% and 3% required reserve ratios against net transaction deposits were reduced to 0% for all banks, essentially removing the reserve requirements altogether. It was replaced with Interest on Reserve Balances (IORB), or interest paid on reserves the banks hold as an incentive rather than a requirement.

Fractional Reserve Banking vs. Other Types of Banking

Most countries today use fractional reserve banking because it is not feasible to use 100% reserve banking. Moreover, a system that requires banks to hold 100% of deposits cannot create more money without devaluing its currency. Thus, banks would need to hold a significant amount of capital to issue loans.

This would greatly reduce growth in developing and developed economies because the banks could not issue debt to businesses and consumers that rely on it for large purchases and investments.

A system backed by precious metals, such as gold, is also prone to this problem. If a specific amount of a country's currency has to be represented by a certain amount of gold, the country is limiting its growth potential because there is a finite amount of gold available. To meet the growing demand for capital, the currency's value would continuously be reduced. Fractional reserve banking allows a country to grow its money supply to meet the demand for growth.

Advantages and Disadvantages of Fractional Reserve Banking

  • Banks don't need to hold vast amounts of capital

  • Banks stimulate the economy by lending

  • Allows for regulation

  • Consumer panic can cause mass withdrawals and lack of capital

  • Too much lending can cause the economy to overheat

Pro Explained

  • Banks don't need to hold vast amounts of capital: Because banks use deposits customers tend to leave in their accounts, fractional reserve banking frees up capital for the economy. This assists in economic growth by keeping money flowing.
  • Banks stimulate the economy by lending: The economy needs capital to grow. Banks meets this need by using funds held in reserve to issue loans to business and consumers. For example, mortgages, auto loans, and other loans are all made possible by fractional reserve banking. Without it, most consumers wouldn't have the means to afford homes and other necessities of modern life.
  • Allows for regulation: Fractional reserve banking enables regulatory agencies to regulate lending practices and influence the economy by guiding interest rates. Without it, banks would be free to charge whatever they wanted.

Cons Explained

  • Consumer panic can cause mass withdrawals and lack of capital: When consumers, investors, and businesses panic about economic circumstances, they tend to run to their banks to withdraw everything they can to prevent further losses. This is called a bank run, and a fractional reserve system keeps them from withdrawing their capital because banks do not physically have it.
  • Too much lending can contribute to economic overheating: When the economy is expanding, it is growing. Consumers tend to spend more, and banks lend more during periods of expansion. When more money is being created through loans, demand can soar, increasing prices. Producers begin producing more to meet demand. This can continue into a situation where the economy overheats, growing too fast.

Criticisms of Fractional Reserve Banking

The one main criticism of fractional reserve banking is that there are insufficient funds for everyone to withdraw at once. However, this is generally not an issue because people won't need to remove all of their capital under most circumstances.

Before the introduction of the Fed in the early 20th century, the National Bank Act of 1863 imposed 25% reserve requirements for U.S. banks under its charge.

This can be witnessed by reviewing the Greek financial crisis that began in 2009. In 2015, Greece defaulted on its debts to the International Monetary Fund amidst a global financial crisis. As a result, citizens flocked to the banks to withdraw their funds, and the banks were forced to close their doors to prevent a complete withdrawal of capital from a struggling system.

Further back in time, at the start of the Great Depression in the U.S., consumers rushed to banks to withdraw all of their funds, leading to the collapse of New York's Bank of the United States.

What Is the Difference Between Fractional Reserve Banking and 100% Reserve?

Fractional reserve banking permits banks to use funds (i.e., the bulk of deposits) that would be otherwise unused and idle to generate returns in the form of interest rates on new loans—and to make more money available to grow the economy. It can thus allocate capital better to where it is most needed. Reserves of 100% require banks to hold all deposited money.

Is Fractional Reserve Banking Legal?

Yes. Most countries use fractional reserve banking because it is currently the only financial system model that works.

Where Did Fractional Reserve Banking Originate?

Nobody knows when fractional reserve banking originated, but it is certainly not a modern innovation. Goldsmiths during the Middle Ages were thought to issue demand receipts for gold on hand that exceeded the amount of physical gold they had under custody, knowing that on any given day, only a tiny fraction of that gold would be demanded.

The Bottom Line

Fractional reserve banking is the banking system used throughout the world today. Banks use fractional reserves to create loans for businesses and consumers. Without the ability to do this, an economy's growth is stunted, leaving it to flounder while those that need money for large purchases and investments rely on a bank's substantial holdings.

Fractional reserve banking is important for modern economies because the alternatives limit the amount of money that can be created or manipulated in an economy to encourage or discourage growth.

Article Sources
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  1. The Federal Reserve. "Federal Reserve Bulletin | June 1993," Page 574.

  2. The Federal Reserve. "Reserve Requirements."

  3. Board of Governors of the Federal Reserve. "Interest on Reserve Balances (IORB) Frequently Asked Questions."

  4. "Bank Run."