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
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.