Fractional Banking

Refers to a system where the banks must maintain a portion of cash reserves deposited by users

Author: Pooja Patel
Pooja Patel
Pooja Patel
Reviewed By: James Fazeli-Sinaki
James Fazeli-Sinaki
James Fazeli-Sinaki
Last Updated:March 12, 2024

What is Fractional Banking?

Fractional Banking is a system that requires banks to set aside a portion of the money deposited as cash reserves. These reserves are kept in case customers want to withdraw their funds, ensuring that there is enough money available for them when needed. This amount cannot be lent or used by the bank.

This reserved money ensures that banks can lend and conduct other activities while maintaining liquidity for individuals who want to withdraw their funds. Banks can store these reserves with the central bank, keep them in their own accounts, or even as physical cash in their vaults.

The amount of money banks must keep in reserve is set by the central bank, and it's called the reserve requirement or reserve ratio. Some banks choose to keep more than this minimum, and that's called excess reserves.

In the US, the reserve ratio is determined by the Federal Reserve, the nation's central bank responsible for setting monetary policy. Historically, the reserve requirement has been 10%, meaning banks are required to hold 10% of the deposits they hold.  

For instance, if someone deposits $500 in a bank with a 15% reserve ratio, the bank can't lend out the entire $500. Instead, it has to set aside $75 (15% of $500) in its reserves. This means the bank can use the remaining $425, or 85%, for lending and other purposes.

Key Takeaways

  • Fractional banking, also known as fractional reserve banking, is a system in which banks must hold a portion of their cash reserves while lending out the remainder of their deposits.
  • The central bank's reserve requirement determines the minimum amount that banks must hold in reserves. Excess reserves are funds held by banks in excess of the minimum required.
  • Fractional banking helps to prevent liquidity issues and bank runs, in which many people withdraw their funds at the same time out of fear of the bank going bankrupt.
  • This system dates back to the gold-trading era and became more popular after the Great Depression to protect depositors' funds and stabilize banks during financial crises.

History of Fractional Reserve Banking 

Most countries in the world use this banking system or have some form of this system in place. 

This system is in place to avoid liquidity issues and crises created by bank runs. Bank runs occur when many individuals withdraw money at the same time due to the fear of the bank becoming insolvent. 

Fractional banking was introduced to resolve the issues bank runs presently. It became more prominent after the Great Depression, when depositors withdrew a significant amount of money all at once, leading to bank runs. 

The government implemented the fractional banking system to protect depositors' funds and banks' interests. While this was around the time when this system was introduced, the concept of fractional banking dates way back to the gold-trading era. 

During this time, in exchange for gold and silver, individuals were given promissory notes, allowing those holding them to claim the funds later. Goldsmiths, at the time, realized that, with the notes in circulation, all depositors would not withdraw money at the same time. 

Thus, goldsmiths started using deposits to issue loans and collect interest. They made the transition from safe keeps to intermediaries. However, there was still a chance that individuals would all come to collect their funds. 

Thus, governments imposed laws that created central control for the banks to avoid such situations. As part of this, they were given the right to make reserve requirements, among other things. The first central bank was created in Sweden, dating back to 1668.  

Fractional Banking Process

Fractional banking is a banking system that allows banks to hold only a portion of the money deposited with them as reserves. The banks use customer deposits to make new loans and award interest on the deposits made by their customers. The reserves are held as balances in the bank’s account at the central bank or as currency in the bank. The reserve requirement allows commercial banks to act as intermediaries between borrowers and savers by giving loans to borrowers and providing immediate liquidity to depositors who want to make withdrawals.

The process of fractional banking involves the following steps

  1. A customer deposits money into a bank account.
  2. The bank holds a portion of the deposit as reserves and lends out the rest to borrowers.
  3. The borrower uses the loan to make purchases or investments.
  4. The recipient of the loan deposits the money into their bank account.
  5. The bank holds a portion of the deposit as reserves and lends out the rest to other borrowers.
  6. The process repeats, with the bank holding a portion of each deposit as reserves and lending out the rest.

Fractional banking allows banks to provide credit, which represents immediate liquidity to borrowers. The banks also provide longer-term loans and act as financial intermediaries for those funds. Less liquid forms of deposit, such as time deposits, or riskier classes of financial assets, such as equities or long-term bonds, may lock up a depositor's wealth for a period of time, making it unavailable for use on demand.

The process of fractional banking expands the money supply of the economy but also increases the risk that a bank cannot meet its depositor withdrawals. Modern central banking allows banks to practice fractional-reserve banking with inter-bank business transactions with a reduced risk of bankruptcy.

Requirements for fractional reserve banking

The reserve requirement, also known as the reserve ratio, is the minimum reserves a bank has to hold per its central bank. While many countries use this system, there are still countries that do not. 

The countries that do not require banks to hold a certain reserve include Canada, Sweden, Australia, the United Kingdom, Hong Kong, and New Zealand. 

Instead of a reserve requirement, these countries have capital requirements, and when in need, the central bank steps in to help by offering up reserves. 

The US uses a fractional banking system. However, not all banks are required to hold reserves. 

Despite this, banks usually keep reserves, as they are paid interest on them. This is known as the interest rate on reserves (IOR) or the interest rate on excess reserves (IOER). This interest acts as an incentive for banks to keep reserves. 

Banks that are required to hold reserves either hold them in the bank's vault or nearest Federal Reserve Bank. In terms of how much, the Board of Governors at the Fed sets the reserve requirement. 

It is an important decision, as increasing the reserve requirements reduces the money supply in the economy, and decreasing the ratio increases it. According to the Board, banks with less than $16.3 million are not required to hold reserves. 

Banks with deposits between $16.3 million and $124.2 million are required to hold at least 3% in reserves. Finally, banks with assets that accumulate to more than $124.2 million have a reserve requirement of 10%. 

To summarize:

Example

Bank Deposits ($USD) Reserve Requirement 
< 16.3M 0%
16.3M < x < 124.2M 3%
> 124.2M 10%

Banks can hold more than the minimum amount, known as excess reserves, but are not required to. However, many banks do in case a situation arises where they would need the extra cash on hand. 

Fractional Banking Calculation and example

The reserve requirement has a simple calculation with two variables: 

  1. Bank deposits 
  2. Reserve ratio 

Reserve Requirement = Bank Depositsx Reserve Ratio

Imagine that you work for a bank in the United States and are tasked with figuring out the bank's reserve requirement. After collecting information, the bank's deposits are valued at $56.7 million. 

With this in mind, you look at the Board of Governors' reserve requirements and find that your bank falls into the 3% reserve ratio category. This means that the bank is free to lend the remaining 97% of its deposits. 

With both pieces of information, you calculate the reserve requirement.

Reserve Requirement = Bank Deposits x Reserve Ratio = 56.7M x 3% = 1.7M

Thus, this bank is obligated to keep a minimum of $1.7M in its reserves or at the Federal Reserve. This value will continue to fluctuate as the bank's deposits increase or decrease and if the bank surpasses a certain threshold. 

For example, if deposits increase, the reserve requirement will increase, and if it decreases, it will shrink. If the deposits recede or exceed a certain threshold, the bank may shift holdings to adhere to the new appropriate reserve ratio. 

The Money Multiplier and Multiplier Effect 

The money multiplier and the multiplier effect are analyzed to gauge the impact reserve requirements have on the economy. The multiplier indicates how much money the bank can create while restricted by the reserve ratio. 

It represents the impact the fractional banking system can have on the money supply and the creation of money. However, note that it is often considered an oversimplification, and many other factors go into making money. 

Specifically, the money multiplier concerns the amount of commercial bank money that can be created. Commercial bank money is deposited in a bank that can be used to write cheques or debit and credit cards. 

This is in opposition to central bank money, which is money created by the central bank, regardless of its form. Thus, this includes metals, banknotes, coins, and whatever the central bank claims are money. 

Calculating the money multiplier is a simple formula with only one variable - the reserve requirement. 

Money Multiplier (m) = 1/ Reserve Requirement 

By changing reserve requirements, the central bank has the power to influence the money supply. For instance, if the reserve requirement is set at 15%, it can create a money supply approximately six times the size of reserves. 

Reducing the reserve requirement increases the multiplier effect, and increasing the need decreases the money multiplier.

Researched and authored by Pooja Patel | LinkedIn 

Reviewed and edited by James Fazeli-Sinaki | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources: