Fractional reserve banking
the practice whereby a bank accepts deposits, makes loans or investments but is required to hold reserves equal to only fraction of its deposit liabilities.
Fractional reserve banking is a monetary system in which banks hold only a fraction of the funds deposited by their customers as reserves. This means that the financial institution is allowed to lend out a portion of the deposited money, typically a percentage of the total deposit, while still keeping a reserve of a certain portion of the deposit. The amount of reserves banks are required to maintain varies by country and is typically set by the central bank or regulatory authority.
For example, if a bank takes in $1,000 in deposits and has a reserve requirement of 10%, it must keep $100 in reserves and is allowed to lend out the remaining $900 to borrowers. Once these funds are lent out, they may be redeposited in other banks and, in turn, lend out as new loans. This process is known as the money multiplier effect and can lead to an increase in the overall money supply.
Fractional reserve banking can create a powerful multiplier effect that can boost economic growth by increasing the supply of loans available to individuals and businesses. However, it also increases the risk of bank runs and other financial instability since banks may not always have enough reserves on hand to meet the demands of withdrawing customers.
Overall, fractional reserve banking has been a cornerstone of modern economic and banking systems. Despite its potential risks, it has stood the test of time and remains widely used today as a fundamental aspect of the banking industry.
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