Fractional reserve banking is an economic system that goes on behind the scenes at the institutions where you keep your money. It allows the bank to keep only a fraction of the money on deposit as cash for withdrawal.
The rest of the funds kept with the bank may be loaned out for other purposes. This allows the bank to make money and stay in business, and it can also help keep the economy humming along.
Learn more about fractional reserve banking, its history, and its pros and cons here.
What Is Fractional Reserve Banking?
The system of banking used most widely around the world today is called Fractional Reserve Banking (FRB). In this system, only some of the money that exists in bank accounts is backed by physical cash that people can withdraw. Banks can then take the extra money and lend it out, which theoretically helps to expand the economy.
This is a debt and interest creation system which is essentially the entire backbone of the modern-day economy.
In simpler terms, if someone goes to the bank and deposits cash, the bank only holds on to a certain amount of that cash, and they lend the rest of that out to individuals and businesses. Most checking accounts don’t pay any interest, so the bank gets to lend out the money for no cost.
Most banks have been required to keep a certain amount of the money that gets deposited available as cash, generally 10%, but this can vary based on the value of deposits held by the bank. This cash is called reserves or the reserve requirement.
Banks also earn interest from the Federal Reserve on the reserves that they hold, which is called the “interest rate on reserves” (IOR). If the Federal Reserve increases the amount of reserves that banks must hold, this takes money out of the circulating economy, and vice versa.
Fractional reserve banking is one of the main ways that banks make money, as they earn on the difference between any interest they pay to customers and the interest they charge borrowers for taking out loans.
💡 Quick Tip: Typically, checking accounts don’t earn interest. However, some accounts do, and online banks are more likely than brick-and-mortar banks to offer you the best rates.
The History of Fractional Reserve Banking
The origins of fractional reserve banking aren’t entirely clear, but the system is generally believed to have been created during the Middle Ages. At that time, more and more people began storing their money in banks, and the banks wanted to be able to transfer coins between customer accounts, rather than storing the exact coins that were deposited until the future time when the customer wanted to withdraw them. This evolved into deposits being treated as a sort of IOU, and the system continued to develop from there.
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Requirements of Fractional Reserve Banking
In addition to the percentage of money that banks are required to keep on hand, there are other requirements set by the Federal Reserve for the fractional reserve banking system. Banks must send reports detailing the deposits, reserve cash, and other information about transactions to the Federal Reserve on a regular basis.
Typically, large banks (whether traditional vs. online) with more than $124.2 million in assets were required to keep 10% in reserves, but smaller banks had different requirements. Banks with assets between $16.3 million and $124.2 million were required to hold 3% in reserves, and banks with under $16.3 million in assets were not required to hold any reserves.
However, in March 2020, the Federal Reserve Board lowered the reserve requirement to 0% across the board.
The Fractional Reserve Multiplier Equation
Although it can’t be calculated precisely, the impacts of fractional reserve banking on the economy can be estimated using what is called the multiplier equation. This equation helps figure out how much money can potentially be created from bank lending.
The equation is:
Initial Deposit x 1/Reserve Requirement
For example, if a bank has $500 million in total assets and it was required to hold 10% in reserves, that would be $50 million. Using the multiplier equation, the calculation would be:
$500 million x 1/10% = $5 billion
This means that $5 billion can potentially be created in the economy through the system of fractional reserve banking. This is different from printing new money and is simply an estimate of the impacts of FRB.
Recommended: Federal Reserve Interest Rates, Explained
Pros of Fractional Reserve Banking
There are both upsides and downsides to the fractional reserve banking system. Some of the pros are:
• Banks can use most of the money that gets deposited to grant loans and earn interest on those loans.
• Banks also earn interest on the reserves they hold.
• The system helps grow the economy.
Most of the time the system works well. Banks make money on interest, money gets released into the economy, and much of the time that money helps borrowers to earn money as well. The idea is that borrowers invest money into their home, business, or other activities, which in turn helps them grow their wealth. They then pay the bank back for the loan and the cycle continues.
Recommended: The Difference Between a Checking and Savings Account
Cons of Fractional Reserve Banking
However, some of the cons of fractional reserve banking are:
• Banks don’t have a lot of physical cash on hand, which can be a problem if there is a bank run. During the Great Depression, most banks had to close because too many people were trying to take cash out and the banks didn’t have enough.
• During an economic downturn (or what is known as a recession), the FRB system largely stops working, since the economy is no longer expanding. The problem with the system is that there is a constant need for economic growth in order to pay back the constantly increasing amounts of debt created through lending. In order to keep growing, more investment is needed, which creates even more debt. When the economy stops growing, there isn’t enough money to pay back all the debt.
• If there is too much inflation, this lowers the value of money.
• If people default on loans, this lowers the price of assets, lowering the value of things like real estate that people hold.
• Sometimes central banks and governments attempt to help the economy or make political moves by making adjustments to the FRB system, such as changing interest rates. Although these changes can sometimes help in the short term, they usually result in long-term negative effects, such as inflation.
• As occurred in the 2009 financial crisis, not all debt is “good” debt, meaning not all of it results in productive economic activity. When it becomes too easy to obtain a loan, inexperienced business owners and real estate investors can get a cheap loan when they can’t necessarily afford it. In the years before 2009, a lot of people took out cheap loans in the peak of the housing market, thinking that housing prices would continue to rise.
The Fed had lowered interest rates so much that practically anyone could take out a loan. When the market crashed, these people weren’t able to pay back loans, and the value of the real estate also crashed.
The economic cycle of upturns and downturns is an inevitable part of the fractional reserve banking system.
The Takeaway
The fractional reserve banking system is an economic system that typically requires banks to keep a certain amount of cash on hand for withdrawals. The rest of the money may be loaned out and used for other purposes, which helps the bank earn money and the economy grow.
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