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 backed by actual cash on hand and available for withdrawal. This is done to theoretically 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 are required to keep on hand a certain amount of the cash that depositors give them, but banks are not required to keep the entire amount on hand.
  • Often, banks are required to keep some portion of deposits on hand, which is known as the bank's reserves.
  • Some banks are exempt from holding reserves, but all banks are paid a rate of interest on reserves.

Fractional Reserve Banking

Understanding Fractional Reserve Banking

Banks are required to keep on hand and available for withdrawal a certain amount of the cash that depositors give them. If someone deposits $100, the bank can't lend out the entire amount.

Nor are banks required to keep the entire amount on hand. Many central banks have historically required banks under their purview to keep 10% of the deposit, referred to as reserves. This requirement is set in the U.S. by the Federal Reserve and is one of the central bank's tools to implement monetary policy. Increasing the reserve requirement takes money out of the economy while decreasing the reserve requirement puts money into the economy.

Historically, the required reserve ratio on non-transaction accounts (such as CDs) is zero, while the requirement on transaction deposits (e.g., checking accounts) is 10 percent. Following recent efforts to stimulate economic growth, however, the Fed has reduced the reserve requirements to zero for transaction accounts as well.

Fractional Reserve Requirements

Depository institutions must report their transaction accounts, time and savings deposits, vault cash, and other reservable obligations to the Fed either weekly or quarterly. Some banks are exempt from holding reserves, but all banks are paid a rate of interest on reserves called the "interest rate on reserves" (IOR) or the "interest rate on excess reserves" (IOER). This rate acts as an incentive for banks to keep excess reserves.

Reserve requirements for banks under the Federal Reserve Act were set at 13%, 10%, and 7% (depending on what kind 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 less than $16.3 million in assets were not required to hold reserves. Banks with assets of less than $124.2 million but more than $16.3 million had to have 3% reserves, and those banks with more than $124.2 million in assets had a 10% reserve requirement.

Beginning March 26, 2020, the 10% and 3% required reserve ratios against net transaction deposits was reduced to 0 percent for all banks, essentially removing the reserve requirements altogether.

Prior to 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.

Fractional Reserve Multiplier Effect

"Fractional reserve" refers to the fraction of deposits held in reserves. For example, if a bank has $500 million in assets, it must hold $50 million, or 10%, in reserve.

Analysts reference an equation referred to as the multiplier equation when estimating the impact of the reserve requirement on the economy as a whole. The equation provides an estimate for the amount of money created with the fractional reserve system and is calculated by multiplying the initial deposit by one divided by the reserve requirement. Using the example above, the calculation is $500 million multiplied by one divided by 10%, or $5 billion.

This is not how money is actually created but only a way to represent the possible impact of the fractional reserve system on the money supply. As such, while is useful for economics professors, it is generally regarded as an oversimplification by policymakers.

What Are the Pros of Fractional Reserve Banking?

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 is thus able to better allocate capital to where it is most needed.

What Are the Cons of Fractional Reserve Banking?

Fractional reserve banking could catch a bank short of funds on hand in the self-perpetuating panic of a bank run. This occurs when too many depositors demand their cash at the same time, but the bank only has, say 10% of deposits in liquid cash available. Many U.S. banks were forced to shut down during the Great Depression because too many customers attempted to withdraw assets at the same time. Nevertheless, fractional reserve banking is an accepted business practice that is in use at banks worldwide.

Where Did Fractional Reserve Banking Originate?

Nobody knows for sure 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 small fraction of that gold would be demanded.

In 1668, Sweden's Riksbank introduced the first instance of modern fractional reserve banking.

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  1. The Federal Reserve. "Reserve Requirements."