What Is Fractional Reserve Banking?

What Is Fractional Reserve Banking?

By Charles Joseph | Editor, Financial Affairs
Reviewed by Corey Michael | Senior Financial Analyst

Fractional Reserve Banking refers to a banking system where banks keep part of the deposits as reserves and loan out the remaining money. Central banks usually regulate this by setting a required reserve ratio that banks have to follow. This system allows banks to create money through the lending process. For example, if someone deposits $1,000 and the reserve ratio is 10%, the bank will keep $100 as reserve and can loan out $900. When this $900 is deposited again in any bank, the bank will keep 10% of it, i.e., $90 as reserve and loan out the remaining $810. This process continues, thereby creating more money in the economy.

Related Questions

1. How Does Fractional Reserve Banking Work?

This banking system works by a bank receiving a deposit, keeping some fraction of it on reserve, and then loaning out the remaining portion. As a result, more money circulates in the economy. The reserved money allows banks to cover withdrawals and provides financial stability.

2. What is the Reserve Ratio?

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The reserve ratio is a central bank regulation that sets the minimum fraction of customer deposits and notes that every bank must hold as reserves. Banks can’t lend out these reserves, ensuring they can meet their obligations as they arise.

3. Can Banks Create Money in a Fractional Reserve Banking System?

Yes, banks can effectively create money through the lending process. When the banks lend out more than their reserves, and those loans are redeposited, this can increase the money supply in the economy.

4. What’s the Importance of the Central Bank in Fractional Reserve Banking?

The central bank plays a critical role in establishing and enforcing the reserve ratio requirements. It also acts as a lender of last resort for commercial banks. By doing so, it helps maintain economic stability and confidence in the financial system.

5. How Does Fractional Reserve Banking Contribute to Economic Growth?

By allowing banks to lend out more money than they hold in reserve, more money is circulated throughout the economy, stimulating spending, investments, and, consequently, overall economic growth. However, it can also lead to inflation if not properly controlled.