What is fractional reserve banking?
Fractional reserve banking is the dominant banking model in modern economies. Under this system, banks hold only a portion of customer deposits as reserves (cash on hand or balances at the central bank) and lend out the remainder. That lending funds investment, consumption, and business activity — expanding credit and, indirectly, the money supply — while depositors retain access to their account balances for payments and withdrawals.
Source: Investopedia (Jessica Olah) — https://www.investopedia.com/terms/f/fractionalreservebanking.asp
Key takeaways
– Banks keep only a fraction of deposits as reserves and lend the rest, generating interest income and supporting economic activity.
– Fractional reserve banking enables money creation through repeated deposit-and-lending cycles (the “money multiplier” effect).
– Reserve requirements used to be a primary regulatory tool, but in many places (including the U.S. since March 2020) required reserve ratios were reduced to zero and regulators now rely on tools such as interest on reserve balances (IORB), capital rules, and liquidity requirements.
– Benefits include more available credit and economic growth; risks include runs (mass withdrawals), liquidity stress, and amplification of credit cycles.
How fractional reserve banking operates (step-by-step)
1. Deposit: A customer deposits funds (e.g., $2,000) in a bank account.
2. Reserve holding: The bank sets aside a required or desired fraction of deposits as reserves (cash in vault + balances held at the central bank). The remainder is available for lending.
3. Lending: The bank originates loans (or buys assets) funded largely by the non-reserved portion of deposits. Borrowers typically deposit the loan proceeds into bank accounts (often in the same or other banks).
4. Re-depositing and re-lending: Those deposits become new sources of funds that other banks can again partially lend out. This repeated cycle is the basis of money creation.
5. Interbank funding & central bank backstop: If a bank needs liquidity (to meet withdrawals or make loans), it borrows in the interbank market or, as a last resort, from the central bank’s discount window (at a penalty-like rate). Central banks also set policy rates that influence the cost of such funding.
Fast fact: The money multiplier (simple model)
– If the reserve ratio is r, the theoretical maximum money multiplier is 1/r.
– Example: If r = 10%, multiplier = 1/0.10 = 10. An initial $1,000 deposit could support up to $10,000 in total deposits across the banking system (i.e., $9,000 of newly created deposit balances from repeated lending and re-depositing), in theory.
– Real-world multipliers are lower because banks hold excess reserves, consumers may hold cash, and regulatory and market liquidity constraints apply.
The money creation cycle (illustrated)
1. Alice deposits $2,000 at Bank A.
2. Bank A keeps 10% ($200) as reserves and lends $1,800 to Bob.
3. Bob deposits $1,800 at Bank B.
4. Bank B keeps 10% ($180) and lends $1,620 to Carol.
5. The process repeats until lending is exhausted by reserves. The cumulative increase in deposit balances is larger than the initial deposit.
Tracing the origins of fractional reserve banking
– Early roots: Practices resembling fractional reserve banking date back to goldsmiths and early money handlers who issued receipts or promissory notes backed by metal deposits and used a portion of those deposits to fund loans.
– U.S. legal/regulatory history:
– National Bank Act (1863) introduced federal oversight and reserve requirements for national banks.
– Federal Reserve Act (1913) created the Federal Reserve System; banks were required to hold reserves with Federal Reserve Banks.
– Reserve ratios varied historically: in 1917 differentiated requirements (e.g., 13%, 10%, 7% for different bank classes); later decades saw higher or varying ratios (e.g., as high as ~17.5% in the 1950s–60s; commonly 8–10% from the 1970s–2010s for many banks).
– On March 26, 2020, U.S. reserve requirements against net transaction accounts were reduced to 0% for all depository institutions. The Fed transitioned to paying interest on reserve balances (IORB) and relied on other regulatory tools (capital, liquidity) to maintain stability.
Comparing fractional reserve banking with alternative models
– 100% reserve banking:
– Banks must keep all deposits on hand (no lending of customer deposits).
– Pros: Eliminates traditional deposit-funded bank runs; simple-to-understand link between deposits and liquid reserves.
– Cons: Severely limits banks’ ability to create loans and expand the money supply; would force a different, likely more expensive, model for funding bank lending (e.g., banks would need to issue explicit debt or equity to fund loans).
– Commodity-backed systems (e.g., gold standard):
– Currency is convertible into a fixed quantity of a commodity, limiting money supply growth and making it harder to respond to economic needs.
– Pros: Perceived monetary discipline and value stability (historically).
– Cons: Constrains growth, can amplify deflationary pressures if commodity supply is stagnant relative to economic growth.
– Modern central-bank-dominated fiat systems with fractional reserves:
– Central banks and other regulators use policy rates, capital rules, liquidity ratios, and macroprudential tools rather than strict reserve requirements to manage systemic risk and money growth.
Weighing the pros and cons of fractional reserve banking
Pros (how it helps economies)
– Enables credit creation: Banks turn otherwise idle deposits into loans for households, businesses, and governments, fueling investment and consumption.
– Efficient use of resources: Only a small portion of deposits need to be kept liquid at any time, allowing more funds to be productive.
– Supports macroeconomic policy: Central banks influence lending and liquidity through policy rates, reserve balances, and liquidity facilities rather than pure asset stock constraints.
– Flexible money supply: Authorities can expand or contract liquidity to respond to shocks without being limited by commodity supplies.
Cons and risks
– Liquidity risk and runs: If many depositors attempt to withdraw simultaneously, banks can face dangerous shortfalls because most deposits are lent out or invested.
– Credit cycles and systemic risk: Banks’ lending behavior can amplify booms and busts; excessive credit growth can cause asset bubbles and instability.
– Moral hazard: Deposit insurance and central bank backstops can encourage risk-taking if not paired with strong supervision (banks may take on greater risk believing they’ll be rescued).
– Inflationary pressure: Unchecked credit expansion can contribute to inflation if money growth outpaces real output, though this is also determined by central bank policy and broader macro factors.
Criticisms of fractional reserve banking
– Lack of full backing: Critics argue depositors’ funds are not fully available if everyone demands cash at once; fractional systems rely on confidence and lender-of-last-resort support.
– Historical bank runs: Events like early-20th-century U.S. bank runs, the collapse of particular banks during the Great Depression, and modern examples (e.g., runs/controls during the Greek crisis) illustrate real-world vulnerability.
– Calls for reform: Some propose 100% reserve banking or other structural changes; others favor stronger regulation (capital/liquidity buffers, resolution regimes) to reduce systemic risk.
Important questions answered
What is the difference between fractional reserve banking and 100% reserve?
– Fractional reserve: Banks lend most deposited funds and keep only a fraction available as reserves. This enables broad credit creation but introduces liquidity risk.
– 100% reserve: Banks must keep all deposits fully liquid. Lending would need separate funding sources (for example, banks would connect savers to borrowers via explicitly invested funds or intermediated securities), limiting spontaneous money creation and commercial-bank-led credit expansion.
Is fractional reserve banking legal?
– Yes. It is the standard legal framework for banking in most countries. Legal requirements differ across jurisdictions and include capital, liquidity, and (historically) reserve regulations. Since March 2020 in the U.S., statutory reserve requirements on transaction accounts were set to 0%, and the Fed instead uses tools such as interest on reserves, capital requirements, and liquidity regulations to manage the system.
Where did fractional reserve banking originate?
– Practices evolved from early money handlers (e.g., goldsmiths) issuing receipts and promissory notes backed by deposits and using a portion of the physical backing to lend. Over centuries, these practices became institutionalized into modern banking, with legal and regulatory frameworks added in the 19th and 20th centuries (e.g., National Bank Act of 1863; Federal Reserve Act of 1913).
Practical steps — what different parties can do
For consumers (protecting your money and making informed choices)
1. Know deposit insurance limits: Use FDIC (U.S.) or equivalent national insurance schemes to ensure deposits are within insured limits; consider spreading large balances across institutions if needed.
2. Keep a liquidity buffer: Maintain emergency cash or liquid accounts to handle short-term needs, especially during crises.
3. Diversify holdings: Use multiple banks or financial instruments (e.g., insured accounts, Treasury bills, money market funds) to reduce exposure to a single institution.
4. Monitor bank health and disclosures: Review bank ratings, capital ratios, and public filings for risk signals; prefer well-capitalized institutions.
5. Understand products: Be clear which accounts are demand deposits (subject to withdrawal) and which investments are not bank deposits.
For bank managers/practitioners (managing liquidity and risk)
1. Maintain appropriate liquidity buffers beyond minimum requirements (cash, central bank balances, high-quality liquid assets).
2. Use stress testing to model deposit outflows and market funding shocks.
3. Access diverse funding sources (retail deposits, wholesale markets, central bank facilities) to avoid concentration risk.
4. Monitor capital adequacy (Tier 1, CET1 ratios) and comply with macroprudential guidance.
5. Price deposit and loan products to reflect liquidity and credit risks, and manage interest-rate risk.
For policymakers and regulators
1. Use a toolkit that includes capital requirements, liquidity coverage ratios (LCR), net stable funding ratios (NSFR), resolution regimes, and macroprudential instruments.
2. Maintain transparent communication to reduce panic and inform markets during stress.
3. Provide credible lender-of-last-resort facilities while designing incentives that limit moral hazard (e.g., clear resolution frameworks).
4. Monitor system-wide leverage and credit growth to preempt excessive risk-taking.
The bottom line
Fractional reserve banking is the operational backbone of modern credit-based economies. It efficiently converts deposits into productive loans, supporting growth and investment, but it depends on confidence, prudent management, and regulatory oversight. Policymakers and banks mitigate inherent risks through capital and liquidity regulation, backstop facilities, and macroprudential tools. For depositors, understanding deposit insurance and liquidity planning reduces personal exposure to systemic events.
Primary source
– Investopedia — “Fractional Reserve Banking” (Jessica Olah): https://www.investopedia.com/terms/f/fractionalreservebanking.asp
If you want, I can:
– Provide a short visual example/calculation of the money multiplier using a specific reserve ratio and starting deposit.
– Summarize recommended steps for a consumer with a specific deposit size (e.g., $250,000 vs. $1 million). Which would you prefer?