Fractional reserve banking is a system that requires banks to keep a percentage of deposits in their customers’ transactional accounts (such as checking and savings accounts) on reserve.
Under the previous U.S. reserve requirement, banks had to keep as much as 10% of deposits in their vaults or with the Federal Reserve. However, this threshold was reduced to 0% in 2020, effectively eliminating the cash reserve requirement for depository institutions.
As a bank customer, you probably didn’t notice when the fractional reserve requirement went away in the U.S. While banks reasoned that the requirement had forced them to raise interest rates on lending and lower interest rates on bank deposits, there was no notable benefit to banking customers after the system ended. Then again, banks had already been hoarding cash in excess of the reserve requirement for over a decade following the 2008 financial crisis.
Still, fractional reserve banking is an important concept to understand as it relates to our modern banking system. Here’s more about what fractional reserve banking is and how it works.
What is fractional reserve banking?
Fractional reserve banking is a system that prevents banks from lending or investing the full amount of their customers’ deposits. Under this system, banks must keep a percentage of deposits on hold or on “reserve.” Depending on the total amount of deposits held by the bank, the requirement ranged anywhere from 0% to 10%.
So if the reserve ratio for a bank was 10%, for example, the bank would be able to lend out 90% of deposits, and be required to hold an equivalent of 10% of the total balances in existing deposit accounts.
Read more: What is private banking, and how does it work?
How does fractional reserve banking work?
The U.S. has had banking reserve requirements in place since 1863, primarily as a means to buffer banks against the fallout from events such as bank runs and other financial panics. Under this system, the Federal Reserve sets the requirement for the minimum percentage of deposits that has to be kept on reserve.
As for the deposits not on reserve (also known as excess deposits), banks use these funds for revenue-generating activities. Here are some of the ways banks use their excess deposits:
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Granting loans to customers, including mortgages, car loans, and business loans
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Lending to local governments in the form of private placements
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Investing in interest-earning securities
Banks also lend to private companies, and large banks finance certain industries en masse. If you’d like to find out where your bank invests its excess deposits, you can search for that information at MightyDeposits.com.
Read more: How do banks make money?
Pros and cons of fractional reserve banking
What are the benefits and failings of the fractional reserve banking system? It depends on who you ask. From a consumer’s point of view, these were the main pros and cons of the U.S. fractional reserve system:
Pros
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Gave bank customers some assurance of access to cash at all times
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Arguably created economic growth by allowing banks to lend/invest money and earn interest
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The Federal Reserve could change the reserve requirement in order to contract or expand the money supply
Cons
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Not proven effective for preventing bank runs or financial panics
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FDIC insurance and government bailouts protected banks from failing when they held too few deposits on reserve
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The demand for withdrawals could easily exceed a bank’s available reserves, especially as technology allowed more bank customers to make automatic, electronic withdrawals
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Put banks in an unstable position since deposits could be redeemed on demand, but the banks’ loans and investments could not
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Banks responded to higher reserve requirements by increasing interest rates on loans and paying lower rates on deposits
Read more: Online banking vs. traditional banking: Which one is right for you?
FAQs
Does the U.S. still have fractional reserve banking?
In March of 2020, the Federal Reserve eliminated the fractional reserve requirement for banks in the U.S. But that doesn’t mean your bank has no cash on reserve. In 2019, the U.S. shifted to an ample reserves framework, in which banks hold “ample” reserves and the Federal Reserve pays them interest on the holdings.
What is the difference between 100% reserve banking and fractional reserve banking?
With fractional reserve banking, banks are required to keep a set portion of their deposits on reserve. With 100% reserve banking, also known as narrow banking, the bank holds all of its deposits at the Federal Reserve or in short-term Treasury bills.
What is one significant consequence of fractional reserve banking?
For consumers, a consequence of fractional reserve banking was unnecessary increases in loan APR and lower earnings on bank deposits. During the fractional banking regime, banks claimed that reserve requirements forced them to increase interest rates on loans and pay lower APY on deposits. However, when the Federal Reserve reduced the reserve requirement to 0%, there were no significant savings passed on to consumers as a direct result.
Is fractional reserve banking good?
Fractional reserve banking has benefits and drawbacks for both consumers and the economy. This banking system required U.S. banks to keep funds on reserve, but still allowed banks to invest the majority of deposits to earn money and potentially support the economy. However, other systems like 100% reserve banking could have different benefits, such as ending the connection between rates on bank loans and bank deposits.