In fractional reserve banking, the bank is only required to hold a portion of customer deposits on hand, freeing it to lend out the rest of the money. This system is designed to continually stimulate the supply of money available in the economy while keeping enough cash on hand to meet withdrawal requests.

If a country has a central bank, it is generally given the authority to influence the money supply and implement other policies to help the economy. One of a central bank’s tools is setting a requirement for banks to hold a specific amount in reserve to meet liabilities or sudden demands for cash.

• What Fractional Reserve Banking Means?
• How does Fractional Reserve Banking Work?
• Does Fractional Reserve Banking Create Money?
• Does the US use Fractional Reserve Banking?
• Does Fractional Reserve Banking Cause Inflation?
• Why do Banks Hold Reserves?
• When did Fractional Reserve Banking Start?
• What are the Significant Pros and Cons of Fractional Reserve Banking?
• How Banks Create Money out of Thin Air?
• What is the Advantage of Fractional Reserve Banking?
• Steps of Fractional Reserve Banking

What Fractional Reserve Banking Means?

Fractional Banking is a banking system that requires banks to hold only a portion of the money deposited with them as reserves. The banks use customer deposits to make new loans and award interest on the deposits made by their customers.

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The reserves are held as balances in the bank’s account at the central bank or as currency in the bank. The reserve requirement allows commercial banks to act as intermediaries between borrowers and savers by giving loans to borrowers and providing immediate liquidity to depositors who want to make withdrawals.  

The fractional banking system came into place as a solution to problems encountered during the Great Depression when depositors made many withdrawals, leading to bank runs. The government introduced the reserve requirements to help protect depositors’ funds from being invested in risky investments.

For example, if a person deposits $1,000 in a bank account, the bank cannot lend out all the money. It is not required to keep all the deposits in the bank’s cash vault. Instead, banks are required to keep 10% of the deposits, i.e., $100, as reserves, and may lend out the other $900. The Federal Reserve sets the reserve requirement as one of the tools for guiding monetary policy.

How does Fractional Reserve Banking Work?

The supply of money grows when banks use funds held in accounts while simultaneously lending them out as loans. For example, when you deposit money into your account, the bank shows 100% of it in your account, but it is allowed to lend some of it to other customers. This acts to increase the amount of money in the economy.

To illustrate how it works, suppose you create a brand-new economy, and you add the first $1,000 to the system.

1. You deposit $1,000 into a bank account. The system now has $1,000.
2. You decide that banks can lend 90% of their holdings. The bank can then lend $900 to its other customers.
3. Those customers borrow $900, and you still have $1,000 in your account, so the system has $1,900.
4. Customers spend the $900 they borrowed, and the recipients of that money deposit $900 into their bank.
5. That bank can lend out 90%, or $810, of the new $900 deposit.
6. Customers borrow the $810. You still have $1,000 in your account, and the recipients of the first $900 still have that money available in their accounts. So the system now has $2,710 ($1,000 + $900 + $810).
7. The cycle, known as the “money multiplier,” continues.

Banks are required to keep on hand and available for withdrawal a certain amount of the cash that depositors give them. If someone deposits $100, the bank can’t lend out the entire amount.

Nor are banks required to keep the entire amount on hand. Many central banks have historically required banks under their purview to keep 10% of the deposit, referred to as reserves. This requirement is set in the U.S. by the Federal Reserve and is one of the central bank’s tools to implement monetary policy. Increasing the reserve requirement takes money out of the economy while decreasing the reserve requirement puts money into the economy.

Historically, the required reserve ratio on non-transaction accounts (such as CDs) is zero, while the requirement on transaction deposits (e.g., checking accounts) is 10 percent. Following recent efforts to stimulate economic growth, however, the Fed has reduced the reserve requirements to zero for transaction accounts as well.

Does Fractional Reserve Banking Create Money?

The modern banking system is considerably different from what the average person believes it to be. Banks are not institutional moneylenders. They do not simply collect money from people and lend them to others. Instead, banks in the modern world have the power to create money when they lend it out. The process by which this happens is called fractional reserve banking.

The process begins with a certain amount of base money. In old times, this base money used to be gold pieces. However, in modern times, reserves are kept at the central bank from this base money. This is often referred to as M0 by economists. This is also the amount of money that exists in the form of physical banknotes and coins. Therefore, at any given point in time, this is the money that has actual physical existence.

Does the US use Fractional Reserve Banking?

In the United States banks operate under the fractional reserve system. This means that the law requires banks to keep a percentage of their deposits as reserves in the form of vault cash or as deposits with the nearest Federal Reserve Bank. They loaned out the rest of their deposits to earn interest. Such banking practices formed the basis for the banking system’s ability to “create” money.

To illustrate the creation of money, suppose an individual deposited one thousand dollars in a bank and the reserve requirement is 20 percent. The bank was required to keep $200 on reserve but could loan out $800. The $800 loan paid for television and was deposited in another bank, which, in turn, kept 20 percent but loaned out $640 to someone else. At that point, $1440 had been created and used for purchases.

The Federal Reserve System affects the nation’s money supply directly by adjusting the number of reserves it requires member banks to keep. If a 15 percent reserve requirement was lowered to 10 percent, more money was available to businesses and individuals for loans. The money supply could increase. In contrast, if the reserve requirement was raised to 30 percent, less money could be loaned, and the money supply shrank.

Does Fractional Reserve Banking Cause Inflation?

Fractional reserve banking is often blamed for many of the problems inherent to an ever-expanding money supply. We hear cries that bankers are creating money to pay their bonuses, or taking too many risks with depositors’ money. However, it is not the fractional reserve, private banking system that is at fault for these problems – it’s the fact that private bank losses are socialized via central bank inflation. 

Fractional reserve banking does not cause inflation in the long run, because the business cycle reins in expansions and contractions in the currency supply. It is instead central banks, with their power to create basemoney, that cause steady inflation over time. By stepping in to save commercial banks when they risk bankruptcy, central banks encourage more risk-taking by commercial banks – causing more crises, more bailouts, and more inflation. 

Fractional reserve banking itself can actually cause price deflation, if banks and individuals use sound money like gold as their base money. Sound money is characterized by its fairly constant supply, which does not change much despite economic conditions, let alone at the whims of a few central bankers and bureaucrats. 

Let’s take the example of a single bank that operates as a fractional reserve bank. This bank holds 100 ounces of gold, but through lending they issue 1,000 currency notes that each represent 1 ounce of gold – giving the bank a 10% reserve ratio. A bad storm hits, knocking out a shipping port and causing many in the city to cut back their spending and look for “safe havens” to preserve their wealth in a time when incomes from trade are dropping. 

Many go to the bank to claim the gold they are owed as prescribed on the currency they hold. In this redemption process, claims are destroyed and gold is returned to owners. However, the overall supply of ‘money’ in the economy does not change, because up to now, currency holders are receiving gold at a 1-to-1 ratio. For every currency note claiming 1 ounce of gold, they are receiving 1 ounce of gold. 

However, the 100 ounces of gold in the banker’s vault is soon running low, and a line forms out the door of angry customers wanting 1-to-1 redemption for their currency. This is known as a ‘run on the bank’ – and the process ends up lowering the value of the currency, possibly wiping it entirely, because all of the sudden people cannot trust that the currency will be redeemable for its face value in gold from the bank. 

This drop in value for the currency against the base money (gold) it represents means an effective shrinking of the overall ‘money supply’. An easy way to think about this is to consider if the banker redeemed the first 100 1-ounce currency notes he received for 1-ounce of gold each.

This would mean there were still 900 currency notes in circulation, each promising the holder 1 ounce of gold from the bank, while the bank now holds exactly 0 ounces of gold. Those 900 currency notes are now worthless, no different than a fancy piece of paper. The economy thus goes from 1,000 units of money valued at 1-ounce of gold each to 100 units of money worth 1-ounce of gold each. 

This type of wind down in currency supply could also happen without a calamity, if all borrowers from the bank repay their loans. However, this would be unlikely to happen, as the bank will simply make more loans when an old loan is repaid, keeping the bank at a constant reserve ratio. 

Why do Banks Hold Reserves?

Bank reserves are the cash minimums that financial institutions must have on hand in order to meet central bank requirements. This is real paper money that must be kept by the bank in a vault on-site or held in its account at the central bank. Cash reserves requirements are intended to ensure that every bank can meet any large and unexpected demand for withdrawals.

In the U.S., the Federal Reserve dictates the amount of cash, called the reserve ratio, that each bank must maintain. Historically, the reserve rate has ranged from zero to 10% of bank deposits.

Bank reserves are primarily an antidote to panic. The Federal Reserve obliges banks to hold a certain amount of cash in reserve so that they never run short and have to refuse a customer’s withdrawal, possibly triggering a bank run.

A central bank may also use bank reserve levels as a tool in monetary policy. It can lower the reserve requirement so that banks are free to make a number of new loans and increase economic activity. Or it can require that the banks increase their reserves to slow down economic growth.

In recent years, the U.S. Federal Reserve and the central banks of other developed economies have turned to other tactics such as quantitative easing (QE) in order to achieve the same goals. The central banks in emerging nations such as China continue to rely on raising or lowering bank reserve levels to cool down or heat up their economies.

When did Fractional Reserve Banking Start?

The year is 1849, a year after the California gold rush began. You are a gold miner. Until now, you have scraped by on what little gold dust you can find. Security has not been a problem for you because you only hold a few ounces of gold at a time. Today after finding pounds of the yellow treasure in a new river bed, you need a place more secure to store your earnings other than your pants pocket.

What do you do now? Storing your earnings at a local bank is a good idea. The banker (we’ll call him Banker Joe) is a smart fellow himself. He realizes that he can only charge so much for gold storage and would like to make more. One day a local business owner comes to him and says, ‘Banker Joe, I sure wish I had the money to expand my store and add a restaurant. There is always a line out the door at the restaurant down the street.’

It is in a moment like this that fractional reserve banking was born. You see Banker Joe now realizes he can lend out a ‘fraction,’ of the deposits from gold miners and charge interest for outstanding loans while providing money to businesses to help them expand.

What are the Significant Pros and Cons of Fractional Reserve Banking?

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 and when it wants to control an economy from getting overheated, it raises the reserve requirement, thereby tightening the money supply.

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.

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.

How Banks Create Money out of Thin Air?

Most people are familiar with central banks’ ability to create money out of thin air. A central bank has access to physical printing presses which can produce physical banknotes, and it has the corresponding ability to create electronic money. However, central banks are not the only entities which create money. Money is also created by regular banks, such as retail banks and commercial banks, in the process of making loans.

Many people believe that regular banks’ ability to create money is similar to central banks’ ability to create money. It is not. This misconception has been perpetuated by a powerful cast of characters which includes mainstream news outlets and even some economists.

What is the Advantage of Fractional Reserve Banking?

In a fractional reserve banking system, banks keep a certain amount of money on hand for safekeeping and then lend the remainder of their deposits out to other people and entities. This system expands the money supply and encourages economic growth, but it also requires firm regulations and safety nets to remain effective through financial crises.

In the United States, the Federal Reserve System oversees this approach to ensure banks maintain a three to ten percent reserve at a minimum and acts as a lender of last resort in the event of a bank run.

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Fractional banking is possible with any medium of exchange. While it’s easier to accomplish with fiat currency (any currency a government issues that is not commodity-backed), banks throughout history have utilized a fractional banking approach whenever they relied more heavily on precious metals, like gold and silver, for money.

Fractional reserve banking has many upsides. Here are three of the most essential to consider:

1. 1. An expanded money supply: Perhaps the greatest benefit of the fractional reserve banking system is its ability to act as a money multiplier. By turning deposits into loans and keeping only a small amount of reserve cash on hand, banks can continuously lend out funds to help further grow the economy. In turn, this allows a greater number of people to then deposit more money in banks, shoring up the system further.
2. 2. Backing by central banks: Fractional reserve banking is generally part of a wider monetary policy set by central banks. For instance, in the United States, the Federal Reserve Bank (colloquially known as the Fed) sets interest rates and reserve requirements and ensures banks it will act as a lender of last resort to keep this system running. This sort of guidance and reassurance from the entity issuing all banknotes in the first place helps keep the fractional approach on track even through difficult economic times.
3. 3. Interest gains for consumers: Bank money accrues interest, whereas simply storing your funds at home can leave you at the mercy of inevitably increasing inflation. As a result, savers can often get a better return on their own personal savings accounts by allowing banks to utilize their money for fractional reserve lending. This comes, however, with the potential risk the bank might not have excess reserves to cover its losses in the event of a financial crisis.

Steps of Fractional Reserve Banking

Fractional reserve banking is complex in practice but easy to understand in theory. By following these three steps, banks can keep enough cash on hand to cover day-to-day transactions while also helping to expand the total circulation of money in the financial system:

• 1. Average people deposit funds. Commercial banks serve as depository institutions for the average person looking to store their money somewhere. Banks often entice depositors by ensuring them they’ll accrue positive interest on the money they store in their bank accounts. Rather than letting these bank deposits just sit there as vault cash, bankers keep a minimum amount on hand and turn the rest of the money into new loans.
• 2. Banks loan out the money. Borrowers come to banks with the hope they’ll have enough money on hand to fund their endeavors. Banks utilize customer deposits to create new money for such requests. These loans serve as assets to the bank so long as they receive prompt payments from those to whom they lend. If enough people were to stop paying back these loans, the loans would then become massive liabilities.
• 3. Cash reserves accrue over time. So long as the economy remains largely stable, the fractional reserve system helps both depositors and banks prosper. Depositors earn interest on the amount of money they keep in the bank at the same time bankers have a greater amount of liquidity. As more and more people deposit their money, the bank also has more reserve cash to cover any losses while still lending out more money to other people or companies.