Fractional-Reserve Banking

Updated Jan 7, 2023

Definition of Fractional-Reserve Banking

Fractional-reserve banking is a banking system in which banks are required to hold only a fraction of their deposits as reserves. That means they can lend out the rest of the money to other customers. This system is used by most commercial banks around the world and is regulated by the central bank of a country.

Example

To illustrate this, let’s say you deposit USD 1,000 in a bank. According to the fractional-reserve banking system, the bank is only required to keep a fraction of this money as reserves. For example, if the reserve requirement is 10%, the bank must keep USD 100 as reserves and can lend out the remaining USD 900. That means, the bank can essentially create USD 900 in new money. If this money is deposited again at another bank, this bank has to keep USD 90 as reserves and can lend out the remaining USD 810, and so on (see also how fractional reserve banking works).

Why Fractional-Reserve Banking Matters

Fractional-reserve banking is an important part of the modern banking system. It allows banks to increase the money supply in an economy by lending out more money than they have in deposits. This, in turn, can lead to an increase in economic activity and growth.
However, it also has its risks. If too many customers withdraw their deposits at the same time, the bank may not have enough reserves to cover all of them. This can lead to a bank run, which can cause a financial crisis. Therefore, it is important for central banks to regulate the fractional-reserve banking system and ensure that banks have enough reserves to cover their deposits.