Fractional Reserve Banking
Fractional Reserve Banking is a system in which only a fraction of bank deposits are backed by actual cash on hand and available for withdrawal. A requirement set by the Federal Reserve as one of the central bank’s tools to implement monetary policy, this banking system requires these banks to keep 10% of the deposit, referred to as reserves. Even though central banks are in charge of controlling the money supply, most of the money in modern economies is created by commercial banks through fractional reserve banking. For the economy and the banking system as a whole, this practice has an important cumulative effect to expand the economy by freeing capital for lending.
- Allows financial institutions to turn $10 of deposits into $100 in loans (with typical 10% reserve requirement
- With $10, a bank can lend out $9
- Someone deposits that $9 in another bank
- That bank can then lend out $8.81 ($9 * .90) to another person
- The process continues -thus creating $100 in loans from $10 in deposits
- This process is what drives the money multiplier and money supply metrics like M2