What Exactly Is Fractional Reserve Banking?

Fractional reserve banking requires just a portion of bank deposits to be withdrawable. Banks need a certain amount of cash and can lend your deposits. By releasing lending money, fractional reserves boost the economy. Most economies employ fractional reserve banking.

Knowing Fractional Reserve Banking

In the bank account contract, you agree to let the bank lend some of your money to other customers. You still have access to the money you deposited, but if you wish to withdraw more than the proportion a bank has on hand, such as the whole sum, the bank will need to access funds from elsewhere to give you your balance.

When you deposit money in your savings account, your bank can utilize the allocated capital to support loans and compensate you for using it. Imagine depositing $2,000 in a savings account. Savings accounts offer interest—usually 0.5% to 2%—and the bank can use some of your money for a loan. The bank may want to lend 80% of your money to other consumers.

You get interest for storing money in a bank account that can make loans.

The Fed sets interest rates. They depend on economic conditions and how to accomplish their twin goals of maximum employment and price stability. A bank can borrow and pay interest from other banks to support loans, withdrawals, debts, and other responsibilities. The discount window, a last resort, allows the Federal Reserve to lend banks money at a greater rate than they charge each other. This encourages banks to borrow from each other rather than the Fed.

The Federal Reserve Board of Governors sets the Federal Reserve target rate range for financial institution interest rates. The effective Federal Funds Rate is the average interest rate banks charge each other.

Fractional Reserve Banking

Fractional reserve banking generates and injects money into the economy. Your bank may lend 90% of your $2,000 deposit and 90% from five other customers’ accounts. It generates $9,000 in lending capital.

Your balance remains $2,000, as do the bank’s borrowers. If all five clients have $2,000 credits, it looks like this:

• You and four other clients have $2,000 in 1% savings accounts.
• The bank has $9,000 in capital if it can lend 90% of its deposits.
• A sixth consumer requests a $1,000 loan.
• The bank borrows $1,000 from five accounts at 10% each.
• Each report has $2,000 ($10,000 total).
• The bank generated $1,000 and loaned it to the borrower at a rate of 5% per year.
• With 1% annual interest on your $2,000, the bank makes a 4% profit.

Fractional Reserve Banking History

Gold and silver trading purportedly spawned fractional reserve banking. Goldsmiths issued promissory notes for trade. The Smiths gave interest-bearing loans with the gold, creating fractional banking.

In 1863, the National Bank Act required banks to hold reserves to protect depositor cash from hazardous investments. The Federal Reserve Act established the Federal Reserve System in 1913. The Fed mandated banks to maintain reserve balances.

Reserve requirements for banks under the Federal Reserve Act were 13%, 10%, or 7% in 1917, depending on their kind. The Fed established the reserve ratio for some banks at 17.5% in the 1950s and ’60s, and it stayed between 8% and 10% from the 1970s until the 2010s.

Banks with less than $16.3 million in assets were exempt from reserves. However, banks with fewer than $124.2 million in assets but more than $16.3 million had to maintain 3% reserves, while those with more than $124.2 million had to have 10%.

All banks eliminated the 10% and 3% reserve ratios against net transaction deposits on March 26, 2020. Interest on Reserve Balances (IORB) supplanted it to incentivize banks to retain reserves.

Comparing Fractional Reserve Banking to Other Banking

Most nations utilize fractional reserve banking because 100% reserve banking is impractical. A system that compels banks to keep 100% of deposits cannot generate money without depreciating its currency. Thus, banks would require lots of capital to lend.

Because banks could not provide loans to firms and consumers that utilized them for significant purchases and investments, this would severely impede growth in emerging and established countries.

Gold-backed systems are likewise susceptible. Gold is limited, restricting a country’s growth potential by requiring a fixed amount of gold to symbolize its currency. The currency would depreciate to accommodate capital demand. Fractional reserve banking lets a country increase its money supply to meet growth.

Fractional Reserve Banking: Pros and Cons

Pro Explained

• Fractional reserve banking frees up economic capital by using consumer deposits. Keeping money flowing boosts economic growth.
• The economy requires capital; therefore, banks lend. Banks lend to businesses and consumers using reserve money. Fractional reserve banking enables mortgages, vehicle loans, and other loans. Most customers couldn’t afford housing and other contemporary requirements without it.
• Allows macroeconomic regulation: Reserve ratios can help central banks regulate the economy. Increasing reserve requirements cut lending, slowing the economy. Reducing reserve requirements boosts lending and the economy. The Federal Reserve seldom uses this instrument, while other central banks, including the PRC, do.

Cons Explained

• Mass withdrawals and capital shortages can result from consumer panic. When consumers, investors, and companies worry about the economy, they hurry to their banks to withdraw whatever they can to avoid losses. A fractional reserve system prevents banks from starting capital during a bank run due to insufficient physical reserves.
• When the economy grows, too much lending can cause overheating. In terms of growth, consumers spend more, and banks lend more. Demand rises as loans produce money, raising prices. Producers increase output to fulfill orders. This can cause the economy to overheat and develop too rapidly.

Fractional Reserve Banking Critics

Insufficient cash for everyone to withdraw is a significant critique of fractional reserve banking. People seldom need to liquidate all their capital, so this is usually not a problem.

Before the launch of the Fed in the early 1900s, the National Bank Act of 1863 mandated 25% reserve requirements for U.S. institutions.

The 2009 Greek financial crisis illustrates this. Greece defaulted on its IMF obligations in 2015 amid a worldwide financial crisis. Citizens raced to banks to withdraw their cash, forcing institutions to close to prevent a complete capital drain from a faltering system.

During the Great Depression, customers withdrew their cash from banks, causing the collapse of New York’s Bank of the United States.

What is the difference between fractional reserve banking and 100% reserve banking?

Fractional reserve banking lets banks utilize the bulk of deposits to produce interest rates on new loans and build the economy. Thus, it can better allocate capital to needs. Reserves of 100% require banks to keep all deposits.

Legal Fractional Reserve Banking?

Yes. Because fractional reserve banking is the only financial system model that guarantees banks a profit, most countries utilize it. Banks would have to charge exorbitant deposit fees to operate without asset earnings.

From where came fractional reserve banking?

Nobody knows when fractional reserve banking began, but it’s not new. Goldsmiths in the Middle Ages produced demand receipts for gold on hand that surpassed the quantity of actual gold they held under custody, knowing that only a small portion would be requested on any given day.

Bottom Line

Global banking uses fractional reserve banking. Banks lend to individuals and companies using fractional reserves. Without this, an economy stagnates as those who need money for significant purchases and investments rely on a bank’s enormous holdings.

Modern economies need fractional reserve banking because other methods limit money creation and manipulation to promote or hinder growth.

Correction—April 9, 2023: Article modified to address calculation error in the hypothetical example in “Fractional Reserve Banking Process.”

Conclusion

• Banks loan out some of their balance sheet deposits under fractional reserve banking.
• Fractional reserve banking boosts lending and the economy.
• Banks must reserve a certain amount of client deposits in most countries.
• Low fractional reserve banks are prone to bank runs because withdrawals may exceed reserves.
• The Federal Reserve eliminated reserve requirements for all depositary institutions on March 26, 2020. Instead, banks receive a reserve interest rate to encourage keeping.