# Understanding Fractional Reserve Banking: How It Fuels Economic Growth

## What Is Fractional Reserve Banking?

Fractional reserve banking is a foundational concept of the modern financial system, used by most economies to drive growth by expanding the availability of capital for lending. This system allows banks to keep [only a fraction of their deposits](https://www.investopedia.com/ask/answers/070815/how-must-banks-use-deposit-multiplier-when-calculating-their-reserves.asp) on hand, lending out the rest to generate returns and stimulate economic activity.

While this process helps optimize the allocation of resources and supports economic expansion, it also carries inherent risks, such as potential liquidity issues during times of mass withdrawals. Understanding how fractional reserve banking operates, and its implications is essential for navigating today's financial landscape.

### Key Takeaways

*   Fractional reserve banking allows banks to keep only a fraction of deposits on hand, using the remainder to create loans and stimulate economic growth.
*   The system is vital for modern economies as it helps increase money supply and meet financial demand, which would be limited under a 100% reserve banking model.
*   Despite criticisms of insufficient funds for mass withdrawals, fractional reserve banking generally maintains stability as simultaneous withdrawals by all depositors are unlikely.
*   The Federal Reserve influences the system by setting interest rates and providing last-resort borrowing options for banks to manage their reserve balances.
*   Changes in reserve requirements, such as the 2020 reduction to 0%, reflect ongoing adaptations to stabilize banks' operations and encourage economic activity.

![Fractional Reserve Banking](https://www.investopedia.com/thmb/EArxQTKqAX5ldFR5lBvVAiO0q3M=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/fractionalreservebanking.asp-final-a5faeb741c464711ba434ee652c40ebf.png)

*— Investopedia / Jessica Olah*

## How Fractional Reserve Banking Operates

When you open a bank account, you agree to let the bank use part of your deposits for loans. You can still access your money, but if you withdraw a large amount, the bank might need to get funds from elsewhere.

When you [deposit money](https://www.investopedia.com/terms/b/bank-deposits.asp) in your savings account, your bank can use an amount specified as capital to fund loans and pay you for using your money. For instance, say you deposited $2,000 in a savings account. Savings accounts pay interest—generally between 0.5% and 2%—so you receive an interest payment on your money, and the bank can use part of it in a loan. In turn, the bank might want to access 80% of your money to use as loans to other customers.

> **Fast Fact**
>
> You receive interest as an incentive for keeping money in an account the bank can use to create loans.

The Federal Reserve sets interest rates based on economic conditions to promote jobs and price stability. If a bank needs funds for loans or expenses, it can borrow from other banks. As a last resort, it can borrow from the Federal Reserve's discount window, which charges a higher rate to encourage banks to first seek funds from each other.

Interest is charged between financial institutions based on a range set by the Federal Reserve Board of Governors called the federal reserve target rate range. The average interest rate banks charge each other is referred to as the effective [Federal Funds Rate](https://www.investopedia.com/terms/f/federalfundsrate.asp).

## The Money Creation Cycle in Fractional Reserve Banking

Fractional reserve banking [injects money](https://www.investopedia.com/terms/d/deposit_multiplier.asp) into the economy. If you deposit $2,000, your bank might lend 90% of it, along with similar parts of others' deposits, creating funds for $9,000 in loans.

Your balance still reflects $2,000, and the customers that the bank borrowed from also see their balances remain unchanged. If all five customers have account balances of $2,000, it will look something like this:

*   You and four other customers have $2,000 each, deposited in savings accounts that pay 1% per year.
*   If the bank can use 90% of its deposits for loans, the available capital is $9,000 (90% of $10,000).
*   A sixth customer asks for a loan of $1,000.
*   The bank borrows 10% from each of the five accounts, totaling $1,000.
*   There is still a balance of $2,000 in each account ($10,000 total between the five accounts).
*   The bank essentially created $1,000 and lent it to the borrower at 5% per year.
*   You receive interest payments of 1% per year on your $2,000, and the bank pockets the difference of 4% as profit.

## Tracing the Origins of Fractional Reserve Banking

Fractional reserve banking supposedly has its roots in an era when gold and silver were traded. Goldsmiths would issue promissory notes, which were later used as a means of exchange. The smiths used the deposited gold to issue loans with interest, and fractional banking was born.

In the U.S., the National Bank Act was passed in 1863 to require banks to keep reserves on hand to protect depositor funds from being used in risky investments. In 1913 the Federal Reserve Act created the system of Federal Reserve banks we now know collectively as the Federal Reserve System. Banks were required to keep reserve balances with the Federal Reserve Banks.

> **Fast Fact**
>
> Reserve requirements for banks under the Federal Reserve Act were set at 13%, 10%, and 7% (depending on the type of bank) in 1917. In the 1950s and '60s, the Fed had set the reserve ratio as high as 17.5% for certain banks, and it remained between 8% to 10% throughout much of the 1970s through the 2010s.

During this period, banks with fewer than $16.3 million in assets were not required to hold reserves. However, banks with fewer than $124.2 million in assets but more than $16.3 million had to have a reserve size of 3%, and those banks with more than $124.2 million in assets had a 10% reserve requirement.

On March 26, 2020, the 10% and 3% required reserve ratios against net transaction deposits were reduced to 0% for all banks, essentially removing the reserve requirements altogether. It was replaced with Interest on Reserve Balances (IORB), or interest paid on reserves the banks hold as an incentive rather than a requirement.

## Comparing Fractional Reserve Banking With Alternative Banking Models

Most countries use fractional reserve banking because holding 100% of deposits isn't feasible. A system requiring full reserves can't expand money supply without devaluing currency. Thus, banks would have trouble offering loans.

This would greatly reduce growth in developing and developed economies because the banks could not issue debt to businesses and consumers that rely on it for large purchases and investments.

A system backed by precious metals, such as gold, is also prone to this problem. If a specific amount of a country's currency has to be represented by a certain amount of gold, the country is limiting its growth potential because there is a finite amount of gold available. To meet the growing demand for capital, the currency's value would continuously be reduced. Fractional reserve banking allows a country to grow its money supply to meet the demand for growth.

## Weighing the Pros and Cons of Fractional Reserve Banking

### Pro Explained

*   **Banks don't need to hold vast amounts of capital**: Because banks use deposits customers tend to leave in their accounts, fractional reserve banking frees up capital for the economy. This assists in economic growth by keeping money flowing.
*   **Banks stimulate the economy by lending**: The economy needs capital to grow. Banks meets this need by using funds held in reserve to issue loans to business and consumers. For example, mortgages, auto loans, and other loans are all made possible by fractional reserve banking. Without it, most consumers wouldn't have the means to afford homes and other necessities of modern life.
*   **Allows for regulation**: Central banks can use reserve ratios as a macroeconomic tool for regulating the economy. Increasing reserve requirements reduces lending, thereby cooling the economy. Decreasing the reserve requirements encourages lending, thereby expanding the economy. This tool is rarely employed by the Federal Reserve but is still used by other central banks, notably the People's Bank of China.  
    

### Cons Explained

*   **Consumer panic can cause mass withdrawals and lack of capital**: When consumers, investors, and businesses panic about economic circumstances, they tend to run to their banks to withdraw everything they can to prevent further losses. This is called a [bank run](https://www.investopedia.com/terms/b/bankrun.asp), and a fractional reserve system keeps them from withdrawing their capital because banks do not physically have it.
*   **Too much lending can contribute to economic overheating**: When the economy is expanding, it is growing. Consumers tend to spend more, and banks lend more during periods of expansion. When more money is being created through loans, demand can soar, increasing prices. Producers begin producing more to meet demand. This can continue into a situation where the economy overheats, growing too fast.

Pros

*   Banks don't need to hold vast amounts of capital
    
*   Banks stimulate the economy by lending
    
*   Allows for macroeconomic regulation
    

Cons

*   Consumer panic can cause mass withdrawals and lack of capital
    
*   Too much lending can cause the economy to overheat
    

## Criticisms of Fractional Reserve Banking

The main criticism is that banks lack enough funds if everyone withdraws at once. However, this is rare since not everyone needs their full balance simultaneously.

> **Important**
>
> Before the introduction of the Fed in the early 20th century, the National Bank Act of 1863 imposed 25% reserve requirements for U.S. banks under its charge.

This can be witnessed by reviewing the Greek financial crisis that began in 2009. In 2015, Greece defaulted on its debts to the International Monetary Fund amidst a global financial crisis. As a result, citizens flocked to the banks to withdraw their funds, and the banks were forced to close their doors to prevent a complete withdrawal of capital from a struggling system.

Further back in time, at the start of the [Great Depression](https://www.investopedia.com/terms/g/great_depression.asp) in the U.S., consumers rushed to banks to withdraw all of their funds, leading to the collapse of New York's Bank of the United States.  

## What Is the Difference Between Fractional Reserve Banking and 100% Reserve?

Fractional reserve banking lets banks use deposits that would otherwise sit idle, earning returns through loans while supporting economic growth. In contrast, 100% reserves require banks to hold all deposits.

## Is Fractional Reserve Banking Legal?

Yes. Most countries use fractional reserve banking because it is currently the only financial system model that allows banks to earn a reliable profit. Without the ability to earn money on their assets, banks would have to fund their operations by charging extremely high deposit fees.

## Where Did Fractional Reserve Banking Originate?

Nobody knows when fractional reserve banking originated, but it is certainly not a modern innovation. Goldsmiths during the Middle Ages issued demand receipts for gold on hand that exceeded the amount of physical gold they had under custody, knowing that on any given day, only a tiny fraction of that gold would be demanded.

## The Bottom Line

Fractional reserve banking is the banking system used throughout the world today. Banks use fractional reserves to create loans for businesses and consumers. Without the ability to do this, an economy's growth is stunted, leaving it to flounder while those that need money for large purchases and investments rely on a bank's substantial holdings.

Fractional reserve banking is important for modern economies because the alternatives limit the amount of money that can be created or manipulated in an economy to encourage or discourage growth.

**_Correction—April 9, 2023:_** This article has been edited to correct a calculation error in a hypothetical example in the section “Fractional Reserve Banking Process.”

> **Article Sources**
>
> 1.  Federal Reserve System.”[Discount Window Lending](https://www.federalreserve.gov/regreform/discount-window.htm).”
>     
> 2.  St. Louis Fed. “[National Bank Act of 1863](https://fraser.stlouisfed.org/title/national-bank-act-1863-1111).”
>     
> 3.  U.S. Senate. “[The Senate Passes the Federal Reserve Act](https://www.senate.gov/artandhistory/history/minute/Senate_Passes_the_Federal_Reserve_Act.htm).”
>     
> 4.  The Federal Reserve. "[Federal Reserve Bulletin | June 1993](https://www.federalreserve.gov/monetarypolicy/0693lead.pdf)," Page 574.
>     
> 5.  The Federal Reserve. "[Reserve Requirements](https://www.federalreserve.gov/monetarypolicy/reservereq.htm)."
>     
> 6.  Board of Governors of the Federal Reserve. "[Interest on Reserve Balances (IORB) Frequently Asked Questions](https://www.federalreserve.gov/monetarypolicy/iorb-faqs.htm)."