All About Fractional-Reserve Banking

In a "fractional reserve banking system," just a small percentage of deposits are guaranteed by readily available funds. In theory, this will help the economy grow by making more funds available as loans. Fractional reserve banking is widely used in today's financial systems.

Reserves are the portion of deposits that banks are obligated to hold on hand. However, not all banks are required to keep reserves, those that do receive interest payments for doing so.

Using Only a Portion of Available Funds, or Fractional Reserve Banking A portion of the funds that customers deposit in banks must be kept in active accounts at all times. A bank cannot lend out the complete $100 that is deposited.

Learning About Banking with Fractional Reserves

And financial institutions need not have the whole amount on hand at all times. Historically, several central banks have mandated that banks operating under their control hold a reserve balance equal to ten percent of all deposits. The Federal Reserve uses this requirement as a tool of monetary policymaking in the United States. If the reserve requirement is lowered, more money enters the economy, while if it is raised, less money enters the economy.

Non-transaction accounts (like CDs) have historically had no necessary reserve ratio, while transaction deposits (like checking accounts) have had a 10% ratio. However, the Federal Reserve has recently taken steps to boost economic growth by lowering reserve requirements to zero for transaction accounts.

Legal Requirements for Maintaining a Fractional Reserve

While not all banks are required to keep reserves on hand, those that do are compensated with a rate of interest. This rate gives a financial institution a reason to hold onto its surplus of reserves.

In 1917, the Federal Reserve Act established reserve requirements for banks at 13%, 10%, and 7%, respectively. The Federal Reserve raised the reserve ratio to 17.5% for some banks in the 1950s and 1960s, and it stayed there for the majority of the 1970s and into the 2010s.

Banks with less than $16.3 million in assets weren't required to have reserves during this time. Banks with assets between $16.3 and $124.2 million were required to maintain a 3% reserve, while those with assets beyond $124.2 million were required to maintain a 10% reserve.

On March 26, 2020, the minimum reserve ratios against net transaction deposits dropped from 10% to 3% for all banks, effectively doing away with the reserve requirements altogether. The National Bank Act of 1863 established mandatory 25% reserve requirements for federally insured U.S. banks. This was decades before the Federal Reserve was established in the early 20th century.

The Impact of Increased Fractional Reserve Holdings

The term "fractional reserve" describes the amount of money kept in reserves as a percentage of total deposits. With $500 million in assets, a 10% reserve of $50 million is required.

When trying to predict how much of an effect the reserve requirement will have on the economy, analysts will often use an equation known as the multiplier equation. Multiplying the initial deposit by one minus the reserve requirement yields an approximation of the amount of money created via the fractional reserve system. In light of the aforementioned data, the total amount is $5 billion ($500,000,000 * 1 - 10%).

However, this is just a simplified illustration of how the fractional reserve system might affect the money supply, not how new currency is created. Policymakers tend to view it as an oversimplification, even if it is valuable for economics instructors.

What Benefits Does Fractional Reserve Banking Offer?

With the help of fractional reserve banking, banks can use the vast majority of their customers' deposits to productive use by charging interest on new loans and therefore generating profits that can be reinvested in the economy. This allows it to direct resources where it will do the most good. Is there a downside to using a system of banking that relies on fractional reserves?

A bank that uses fractional reserve banking could run out of money during a bank run, which feeds on itself. This happens when a large number of depositors try to withdraw money all at once from a bank that only has, say, 10% of deposits in liquid cash on hand. During the Great Depression, too many people tried to take their money from banks at once, forcing several in the United States to close. Even so, fractional reserve banking is standard procedure at financial institutions around the globe.