Next video:
Loading the player...

Fractional reserve banking is the banking system most countries use today.

It requires banks to hold only a fraction of the money their customers deposit. That amount is the reserve requirement, and in most countries it’s set by the central bank. Banks can loan the rest of their deposits to other customers, which serves to expand the economy.

It works like this:

Banks accept deposits from individuals and businesses, providing them with savings and checking accounts in return. Banks can loan out the bulk of those deposits to other customers to buy homes or cars, start businesses or to fund other projects.

If a customers deposits $100,000 into a bank, and the reserve requirement is 5%, the bank can loan $95,000 out to other customers.

Once the bank has loaned out $95,000, it in essence has created $195,000. Customers borrow that $95,000 and deposit some, or all, of it into other banks. If the reserve requirement is still 5%, then the other banks can loan $90,250 to new customers. And the process keeps repeating itself.

Financial crises occur when the fractional banking system breaks down and the money supply does not expand.

Many U.S. banks had to shut down during the Great Depression because so many people attempted to withdraw their money at the same time. Today, safeguards exist to prevent such an occurrence.

Related Articles
  1. Personal Finance

    Retail Banking vs. Corporate Banking

    Retail banking is the visible face of banking to the general public. Corporate banking refers to the aspect of banking that deals with corporate customers. Check out more on the differences between ...
  2. Investing

    Introduction To The Chinese Banking System

    As China steps into a greater role in the global economic system, their banking system continues to evolve.
  3. Personal Finance

    How Banks Set Interest Rates on Your Loans

    Are you planning on getting a loan from bank? Here is the information you need know on how banks set the interest rates to get the best possible deal.
  4. Insights

    How the Federal Reserve Manages Money Supply

    Find out how the Federal Reserve manages bank reserves and how this contributes to a stable economy.
  5. Personal Finance

    Bank of America to Cut 8,000 Jobs (BAC)

    Bank of America's president of retail banking has announced thousands more positions to be eliminated in the coming years.
  6. Investing

    JPMorgan Anticipates More Midsize Bank Mergers

    Now that the Fed's quantitative easing program is over, deposits once booming in retail banks' coffers are draining.
Trading Center