Fractional reserve banking is an economic system that goes on behind the scenes at the institutions where you keep your money. It allows the bank to keep only a fraction of the money you deposit as cash for withdrawal.
The rest of the funds may be loaned out for other purposes. This allows the bank to make money and stay in business, and it can also help keep the economy humming along.
Here’s a closer look at fractional reserve banking, its history, and its pros and cons.
Key Points
• Fractional reserve banking allows banks to lend out most of the deposits, keeping only a fraction in reserve.
• This system helps stimulate economic growth by increasing the availability of funds for loans and investments.
• Reserve requirements have been reduced to 0% by the Federal Reserve, with interest on reserve balances serving as an incentive.
• Advantages of fractional reserve banking include economic growth, while disadvantages include potential bank runs and financial instability.
• Government insurance protects depositors up to $250,000, maintaining public confidence in the banking system.
What Is Fractional Reserve Banking?
The system of banking used most widely around the world today is called Fractional Reserve Banking (FRB). In this system, only some of the money that exists in bank accounts is backed by physical cash that people can withdraw. Banks can then take the extra money and lend it out, which theoretically helps to expand the economy.
In simpler terms, if someone goes to the bank and deposits money into their account, the bank only holds on to a certain amount of that cash, and they lend the rest of that out to individuals and businesses. This encourages spending and investing and puts more money into the economy as a whole.
Fractional reserve banking is also one of the main ways that banks make money, as they can see earnings from the difference between any interest they pay to customers and the interest they charge borrowers for taking out loans.
💡 Quick Tip: Typically, checking accounts don’t earn interest. However, some accounts do, and online banks are more likely than brick-and-mortar banks to offer you the best rates.
The History of Fractional Reserve Banking
The origins of fractional reserve banking aren’t entirely clear, but the system is generally believed to have been created during the Middle Ages. At that time, more and more people began storing their money in banks, and the banks wanted to be able to transfer coins between customer accounts, rather than storing the exact coins that were deposited until the future time when the customer wanted to withdraw them. This evolved into deposits being treated as a sort of IOU, and the system continued to develop from there.
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Requirements of Fractional Reserve Banking
In the past, the Federal Reserve (aka “the Fed”) required banks of a certain size to have a set percentage of funds tied up in reserves. Prior to March 2020, large banks (whether traditional vs. online) with more than $124.2 million in assets were required to keep 10% in reserves, but smaller banks had different requirements. Banks with assets between $16.3 million and $124.2 million were required to hold 3% in reserves, and banks with under $16.3 million in assets were not required to hold any reserves.
These reserves could be held by the bank itself or put into an account at the Federal Reserve, known as a reserve balance.
However, in March 2020, the Federal Reserve Board lowered the reserve requirement to 0% across the board and replaced it with Interest on Reserve Balances (IORB) as an incentive for banks to maintain reserves, which banks continue to do. Typically, banks have enough money in reserve to accommodate everyday business, including all withdrawals.
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The Fractional Reserve Multiplier Equation
Though it’s not relevant with today’s 0% reserve requirements, the multiplier equation has been used in the past to estimate the impacts of fractional reserve banking on the economy. This equation helps figure out how much money can potentially be created in the financial system from bank lending, which sets off a chain reaction of economic activity.
For example, let’s say you deposit $1,000 in a bank and the bank keeps $100 and lends out the remaining $900 to John who needs money to pay for a home repair. John pays the contractor, who then deposits that $900 in another bank, which then keeps $90 and lends out $810, and so on. This pattern continues, effectively multiplying the original deposit.
The fractional reserve multiplier equation is:
Initial Deposit x 1/Reserve Requirement
So if a bank has $500 million in total assets and it was required to hold 10% in reserves, that would be $50 million. Using the multiplier equation, the calculation would be:
$500 million x 1/10% = $5 billion
This means that $5 billion can potentially be created in the economy through the system of fractional reserve banking. This is different from printing new money and is simply an estimate of the impacts of FRB.
Recommended: Federal Reserve Interest Rates, Explained
Pros of Fractional Reserve Banking
There are both upsides and downsides to the fractional reserve banking system. Some of the pros are:
• Banks can use most of the money that gets deposited to grant loans and earn interest on those loans.
• Banks also earn interest on the reserves they hold.
• The system helps grow the economy.
Most of the time the system works well. Banks make money on interest, money gets released into the economy, and much of the time that money helps borrowers to earn money as well. The idea is that borrowers invest money into their home, business, or other activities, which in turn helps them grow their wealth. They then pay the bank back for the loan and the cycle continues.
Recommended: The Difference Between a Checking and Savings Account
Cons of Fractional Reserve Banking
However, some of the cons of fractional reserve banking are:
• Banks don’t keep 100% of deposits on hand, which can be a problem if there is a bank run. During the Great Depression, a significant number of banks had to close because too many people were trying to take cash out and the banks didn’t have enough. (These days, the government insures deposits of up to $250,000 per depositor, per institution and account ownership type, which means you can’t lose your money — up to the insured limit — in the rare event of bank failure.)
• If the bank creates too much money and lends it out unwisely, it can lead to economic instability, inflation, and financial crises.
• Banks can respond to higher reserve requirements by increasing interest rates on loans and paying lower annual percentage rates (APYs) on deposits.
The Takeaway
The fractional reserve banking system is an economic system that typically requires banks to keep a certain amount of cash on hand for withdrawals. The rest of the money may be loaned out and used for other purposes, which helps the bank earn money and the economy grow.
This is going on behind the scenes when you bank. Many people are interested in finding a bank that suits their financial and personal needs, however, with features such as a competitive interest rate and rewards.
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FAQ
What is fractional reserve banking in simple terms?
Fractional reserve banking is a system where banks are only required to keep a small portion of customer deposits in reserve — usually to meet withdrawal demands — and can lend out the rest. The money banks loan to individuals and businesses then gets deposited back into other banks, repeating the process, and creating more money in the economy.
How do banks create money from a $1,000 deposit?
When you deposit $1,000 in a bank, the bank may keep a fraction — say 10% or $100 — and lend out the remaining $900. That $900 might be spent and redeposited in another bank, which then keeps $90 and lends out $810, and so on. This cycle continues, essentially multiplying your original deposit. Through this process, known as the money multiplier effect, banks create money by expanding the money supply beyond the original deposit.
How much money are banks required to have on hand?
Historically, banks have been required to keep a certain percentage of customer deposits in reserve, known as the reserve requirement. This percentage is set by the Federal Reserve (aka “the Fed”) and was generally around 10%, meaning banks had to keep $100 on hand for every $1,000 in deposits. However, in March 2020, the Fed reduced the reserve requirement to 0%.
While banks don’t currently have a specific minimum requirement, they still maintain reserves for operational needs and to comply with other regulations.
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