Fractional Reserve Banking: Definition & Characteristics (2024)

Fractional Reserve Banking System Definition

As we know, banks hold our money in various types of deposit accounts, making that money available to depositors whenever they wish to withdraw. When banks take in deposits, they lend that money back out to consumers and businesses, creating a multiplier effect by essentially adding more money into the economy, which creates more deposits, and so on. This system allows banks to make a profit on the interest they charge for loans. The effect is that depositors have a safe place to keep their money, and the economy is stimulated by the extra money banks effectively put into circulation with their loans.

Under normal conditions, there is enough money being deposited and withdrawn so that banks have sufficient cash to facilitate all withdrawals. But if there was a panic and everyone decided they wanted their deposits back at once, banks would risk collapse, as they would not be able to call in all the money loaned out to cover the necessary withdrawals. For this reason, U.S. banks are required to hold a portion of their deposits in reserve for safety and liquidity, rather than lend it all out.

The amount of money that banks are required to hold back is set by the Federal Reserve as a percentage of total deposits, and the Fed changes the reserve requirement periodically to ensure the safety of the banking system as well as to influence the money supply. This essentially describes the fractional reserve banking system. Since the amount of money available can affect inflation, interest rates, and other economic variables, the Fed changes the reserve requirement at banks when necessary to help keep those variables under control.

Tip: Fractional Reserve Banking does increase the possibility that a bank could fail if too many depositors wanted their money at the same time. To protect your assets, once your deposits exceed the amount of money protected by FDIC insurance at any one bank, you should consider keeping part of your assets in a different bank.

Fractional vs. Full-Reserve Banking

Not all bank deposits are the same. There is a distinction between demand deposits, such as checking and savings accounts, which have no restrictions or penalties on withdrawals, and time deposits, such as CDs, which have restrictions and penalties for withdrawing early. Since there is much less risk that CD holders will all want their money back at the same time, the reserve requirement is typically lower for those deposits or even zero.

With the demand deposits, however, there is usually a fractional reserve requirement. If that requirement is 10%, the bank can lend out 90% of their demand deposits. In a full-reserve scenario, the bank would have to keep 100% of the deposits in the bank and lend out 0%. No banks currently operate under a full-reserve scenario, though in the middle ages, that’s the way all banks operated. Considering that in a full-reserve scenario, a bank cannot lend customers’ money out and make a profit on it, the bank would need to charge customers interest just to hold the money in safekeeping.

Reserve Banking History

Fractional reserve banking dates back to Sweden in the 17^th century and to the U.S. in 1791. The system's big test in the U.S. came as a result of the Crash of 1929. In the aftermath of that event, some 1300 banks failed in the U.S. by the following year as people withdrew their deposits in panic.

In 1934, the Federal Deposit Insurance Corp (FDIC) was set up to provide further protection for consumers in the event of a bank failure. When the fractional reserve banking system was again tested in the 2008 market crisis, Washington Mutual declared bankruptcy over its real estate loan losses but all depositors were made whole by the FDIC.

How Fractional Reserve Lending Works

Fractional reserve lending allows banks to lend against deposits not otherwise held in reserve. If the reserve requirement is 10% of deposits, then a bank can lend up to 90% of deposits. If there is no reserve requirement, as with time deposits, for example, the bank can lend out up to 100% of the deposits.

As the bank lends money, that money is used for purchases, which can generate additional deposits. These, too, may be loaned to customers subject to the reserve requirement.

How Fractional Reserves Are Used

In its role as the central bank in the US, The Federal Reserve uses the fractional reserve system to help regulate the supply of money in circulation as well as the overall safety of the banking system. When the Fed wants to stimulate the economy, it lowers the reserve requirement. When it wants to control an economy from overheating, it raises the reserve requirement, thereby tightening the money supply.

Reserve Ratio

The percentage of deposits required to be kept in reserve is also called the reserve ratio. The formula for the reserve ratio is as follows:

Reserve ratio = Reserve requirement/Total deposits

Characteristics of Fractional Reserve Banking (Pros & Cons)

Pros

• Allows banks to make money from deposits, thus relieving depositors of the necessity to pay the bank for safekeeping their money.
• Allows banks to stimulate growth in the economy by lending capital to individuals and businesses.
• Allows the Fed to regulate the money supply in the economy and ensure bank safety by modifying the reserve requirement.
• Has a multiplier effect that essentially creates additional money from base deposits.

Cons

• Can increase the risk of bank failure.
• Concerns some economists that it can overheat the economy.

Bottom Line

Fractional Reserve Banking is the way banks throughout the world operate today. It allows banks to lend out most deposits, subject to maintaining a set fraction of the deposits in reserve. This provides a way for banks to earn a profit, while stimulating economic growth and helping their customers buy homes, start businesses, etc.