Fractional-reserve banking is the common practice by commercial banks of accepting deposits, making loans or investments, but only keeping a fraction of each deposit on hand as reserves (i.e., cash in their vaults and deposits at the central bank). This is a fundamental characteristic of modern banking.
Here’s how it works in practice:
- When you deposit, for example, $1000 into your bank, the bank doesn’t keep all of your money on hand. Instead, it’s required by law to keep a fraction of it, say 10%, or $100, as reserves.
- The remaining $900 can then be lent out to other customers. This money will eventually be deposited back into the banking system, and the process repeats, meaning the original deposit is multiplied throughout the economy.
- It’s important to note that this process increases the money supply. The original $1000 deposit can, theoretically, create up to $10,000 in the banking system (if the reserve requirement is 10%).
Fractional-reserve banking can lead to a rapid expansion of credit and is an important part of the monetary policy implementation. It also involves a certain level of risk; if all depositors decide to withdraw their money at once (a bank run), the bank will not have enough reserves to cover these withdrawals. This is one reason why central banks typically serve as a ‘lender of last resort’.