What is fractional reserve banking?

1. A customer deposits money in a bank. 
2. The bank hangs onto a percentage of that deposit for its reserve funds, kept as cash or sent to the central bank balance (at the Federal Reserve). The bank issues a loan, which results in a new deposit being credited to the borrower’s account.
3. That new loan gets spent somewhere or deposited back into another bank account. Once again, the bank holds back a percentage of the new deposit, then loans the rest — and this process can expand the amount of deposit money in the system, a concept often described as the “money multiplier.”  

The Federal Reserve System (the Fed) sets minimum reserve requirements for U.S. banks, which ensures they keep a certain percentage of funds on hand. That requirement has been zero since 2020, but it has been as high as 10% in previous years. 

The “money multiplier” is a simplified model used to illustrate how bank lending can expand deposit balances under a given reserve requirement. It’s a simple formula: 1 divided by the reserve ratio (minimum reserve requirement). 

For example, if the Fed set a 10% minimum reserve requirement, the money multiplier formula would be as follows: 1 / .10 = 10. Ten is the money multiplier, which means, in theory, a 10% reserve requirement implies that each dollar of reserves could support up to $10 in deposit balances across the banking system, assuming other constraints do not apply.

However, banks generally aren’t loaning out every dollar possible based on the money multiplier. For example, many banks may hold more money in reserves based on regulations or guidelines issued by other agencies, like the FDIC. Banks may also keep a close eye on their reserves and assets in comparison to debts or liabilities to better protect against liquidity issues, which generally offers more protection for depositors. 

• Facilitates lending & credit creation: More loans and lines of credit can be created since banks are only required to hold a percentage of deposit funds in reserve.
• Supports economic growth and money supply expansion: Keeping a small percentage of reserve funds and using the rest to fund new loans expands the supply of available money. Increased lending can support economic activity by making financing more accessible for businesses and households, which may contribute to higher spending and investment.
• Enables deposit accounts & payment systems while financing loans: Bank customers aren’t likely to withdraw 100% of their deposits at once, which gives banks the ability to finance loans, collect interest on those loans, and in some cases pay interest to customers who hold eligible interest-bearing deposit accounts.

• Liquidity risk and bank runs: This system operates on the expectation that customer withdrawals will be spread over time rather than occurring all at once — known as a bank run. If a bank run happens, the bank may not have enough reserves to support the withdrawals, which could result in bank failure.
• Money creation can fuel instability: Fractional reserve banking expands the money supply by creating new deposit balances when banks issue loans. So, if one bank fails due to a bank run, there is the potential for stress to spread to other financial institutions, particularly if confidence in the banking system declines.
• Mismatch of maturities & interest rates: Banks use money from cash deposits, which can be withdrawn at any time, to provide long-term loans — say, a 30-year mortgage. While customers can withdraw cash at any time, banks are obligated to honor those long-term loans their customers have taken out, leading to a mismatch of maturities. Simultaneously, banks make their money by paying lower interest rates on deposits while collecting higher interest rates for money lent out. Banks are obligated to pay interest on deposits as promised. If enough people default on their loans, the bank isn’t bringing in profit from loans. This could lead to issues like the inability to pay interest on deposits or issue withdrawals on demand.
• Dependence on central bank backstop and regulation: The central bank acts as a backstop for banks, providing emergency funding if they don’t have enough money in reserve. Though an option, this shouldn’t be a bank’s first move if they have liquidity issues. Regulations control reserve minimums, which can be helpful but could lead banks to rely too much on regulators rather than understanding what reserves are needed for their situation.

Full-reserve banking means a bank hangs onto 100% of demand deposits that come in.

Fractional reserve banking means more loans can be made from deposits, translating into a bigger pool of money that can drive economic growth. However, banks could experience liquidity issues if they don’t keep enough reserves on hand.

Full-reserve banking is often described as reducing liquidity risk for depositors, though it comes with trade-offs in terms of lending capacity. This limitation could slow economic growth because fewer dollars would be available for loans and large purchases.

Fractional reserve banking supports a higher level of lending and deposit creation within the economy, which is why it has become the dominant banking model in most countries.

Central banks set rules, such as minimum reserve requirements, and serve as a sort of safety net for banks. The Federal Reserve System is the United States’ central bank, but each country or region will have its own version.

Prior to 2020, minimum reserve requirements for banks were based on how many assets a bank had, with requirements ranging from 0-10%. In 2020, the Federal Reserve eliminated its minimum reserve requirement and instead offers interest on cash reserves. Overall, this represents a move from the Fed issuing mandates to banks and instead providing incentives (like paying interest) to encourage banks to increase their reserve funds. 

While reserve requirements were removed, other regulatory safeguards were strengthened to manage liquidity and capital risk. Plus, central banks hold a lot of power in the fractional reserve banking system (through actions like setting interest rates and reserve requirements), which heavily impacts monetary policy.

Rather than reserve requirements, the Fed started paying interest on the money that banks keep with the Fed, which is part of a newer policy known as the ample reserves framework. There has also been more of a focus on capital standards for banks, rather than a focus on simply hitting a minimum reserve requirement.

Fractional reserve banking allows banks to pay customers interest on their cash deposits while also contributing to economic growth by loaning dollars to more people. This system operates alongside regulatory safeguards designed to reduce risk and protect depositors, such as liquidity rules, capital requirements, and deposit insurance schemes, each with defined limits. Because it’s the norm in the banking world today, understanding how fractional reserve banking works can help you better interpret how banks manage deposits and loans.

The above article is intended to provide generalized financial information designed to educate a broad segment of the public; it does not give personalized tax, investment, legal, or other business and professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other business and professional matters that affect you and/or your business.