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The Banking System

Fractional Reserve Banking

Fractional reserve banking is the system by which banks set aside a portion of their deposits and loan out the remainder or invest it in other ways, which creates money.

Fractional reserve banking is a system of banking under which commercial banks hold a portion of their deposits and use the remainder to increase revenue through loans and investments. A commercial bank is a private financial institution primarily concerned with maximizing its revenue through holding deposits, offering checking services to the public and businesses, and making loans and investments. The amount of money a bank has held back from deposits received, which is not available to loan or invest, is called its required reserves.

By law, the federal government requires all banks to keep a portion (i.e., the required reserves) of every dollar deposited in reserve. This law is set in place as a safety precaution to ensure that banks do not collapse and lose their investments.

The amount of required reserves a bank must keep on hand is based on the bank's liabilities. A bank's liabilities are the money consumers have placed in the bank for safekeeping, called a demand deposit. Demand deposits are deposits customers can withdraw without advance notice or warning.

For example, assume the Federal Reserve requires a bank to keep 10% of its deposits as reserves. If a customer deposits $100 into a bank account, the bank holds $10 in reserve. The bank can use the remaining $90 in excess reserves to invest, loan to individuals, and engage in other profit-making measures. Excess reserves are the amount of money a bank has available to loan or invest, made up of all deposits minus the required reserves; in other words, the reserves held in excess of the reserve requirement required by regulators. Later, the customer may withdraw their $100, by which time the bank will have profited from the $90 it loaned out or invested.

Fractional reserve banking also increases the national money supply, which is the amount of money free to circulate and power economic activity in an economy. As an example, instead of $100 being deposited and remaining unavailable for use, $90 circulates in the economy and contributes to economic activity and growth, while $10 remains in the bank as reserves.

Fractional Reserve Banking

Fractional reserve banking creates an expansion on $100. Each curve terminates at the point where expansion stops. This value is calculated by the money multiplier, which is 1/RR1/\text{RR}, where RR is the required reserve ratio. For example, when RR=20%\text{RR} = 20\%, with an initial deposit of $100, the expansion is calculated as $100×1/0.2=$500\$100 \times 1/0.2=\$500.
Fed Member Banks collaborate with Federal Reserve banks by often holding their deposits in one of the Federal Reserve branches. When a customer deposits $100 in the bank, the fractional reserve bank places the $10 it must set aside in reserve in a Federal Reserve bank.

Banks rely on some individuals saving money and others borrowing money. To stimulate these activities, banks must have cash on hand from individual savings to offer to borrowers. Confidence in banks is necessary to ensure that people will make deposits.

The larger the bank, the more reserves it must hold, according to the regulations created by the Federal Reserve. This regulation exists to discourage and impede a run on a bank. A run on a bank is when many of a bank's depositors choose to withdraw their funds at the same time, often because of a perception of financial weakness in the bank, which then causes the weakness people feared in the first place. Bank runs throughout the banking system were one of the most damaging aspects of the Great Depression, the time of severe economic downturn in the 1930s.

The Federal Reserve decides the percentage of reserves each bank must have. The percentage is relatively low, allowing most assets to remain liquid and in circulation in the economy, which keeps the cost of credit low as well. The system of fractional reserve banking only functions as long as people are taking out loans, repaying loans, and depositing money in banks.