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What is fractional reserve banking?

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Last editedJun 20212 min read

What happens to your money when you make a deposit? While it should be available for withdrawal when you need it, this doesn’t mean the cash sits there the whole time. The fractional reserve banking system requires that the bank retains a certain percentage of deposits at any given time. Here’s a closer look at the fractional reserve banking definition, along with how the system works.

What is fractional reserve banking?

Under a fractional reserve banking system, banks are required to hold onto a percentage of customer deposits in their reserves. However, the bank is free to invest or lend out the remaining percentage. Small deposits are pooled together to make loans, and money that would just be sitting there is put to work in investments. This allows banks to make money and grow the economy, while still ensuring that there are funds available to cover customer withdrawals.

The fractional reserve banking system was originally set up after the Great Depression. After the 1929 stock market crash and resulting depression, depositors made repeated withdrawals which tapped out the bank reserves. Reserve requirements were introduced by the US government as a solution, ensuring that a fraction of depositor funds was required to be kept safe from risky investments.

Understanding the fractional reserve banking system

When you log into your bank account online, you’ll see your full balance displayed on the screen. Yet under a fractional reserve banking system, the bank’s allowed to lend 90% of this deposit out to other customers. The system’s designed to grow money supply in the economy by showing the same lump sum simultaneously used in two ways: as a deposit and as an investment.

Here’s a quick illustration to help explain the fractional reserve banking definition. Imagine that you’ve started a new economy with its first $100.

  1. Step 1: You deposit $100 into a bank account, giving the system $100.

  2. Step 2: The bank lends 90% of the deposit to another customer, or $90.

  3. Step 3: You still have $100 in your account, but the other customer now also has $90, which he deposits into his own bank account.

  4. Step 4: The system, or economy, now has $190 – almost doubling its money supply. This is known as the “money multiplier” effect.

As the bank continues to lend out 90% of its deposits, more money enters circulation which can be spent on goods and services. The sellers of those goods and services deposit their revenue into new bank accounts. Money supply continues to grow, while the bank retains 10% of deposits in its reserves for safekeeping. The speed at which money moves through the economy is called the velocity of money.

What is fractional reserve banking: reserve requirements

The Federal Reserve sets the reserve requirements for banks. This is the minimum percentage of deposits that must be retained in reserve. The money can be held in bank vaults as cash or deposited with Federal Reserve banks.

Up until 2020, the reserve requirement was 10% for banks holding over $124.2 million in assets. In other words, for every $100 deposited, the bank can lend $90. However, this was changed on March 26, 2020 when the Federal Reserve reduced the requirements to zero as a temporary measure to stimulate the pandemic-stricken economy.

The downsides of fractional reserve banking

There are many benefits to a fractional reserve banking system, not least of which is its ability to work as a money multiplier to stimulate the economy. It also ensures that banks have some amount of cash on hand to cover customer withdrawals.

However, there is always the danger of bank runs. This is what happened during the Great Depression, when customers lost trust in the banking system and rushed together to withdraw all their money. If this happens, the bank is unable to pay everyone and becomes insolvent. Fortunately, the Federal Deposit Insurance Corporation (FDIC) provides insurance to cover consumer deposits and boost trust.

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