Fractional reserve banking is a banking system where banks retain less than 100 percent of their deposits in their vaults or on deposit with the central bank. This enables banks to lend out more than they hold on deposit for their customers and results in growth in the money supply.
If banks kept all of their deposited money in their vaults, they would have no money to lend. Furthermore, they would need to charge their depositors for safekeeping their money since they would have no other source of revenue. The fractional reserve banking system facilitates the growth of the money supply and economy because banks are only required to keep a fraction of their deposits on reserve. The rest can be loaned to households, businesses, and governments to spur economic growth.
Loans increase the money supply. To illustrate, assume Julie deposits $1,000 in Bank A. Bank A then lends $850 to Joe. Bank A does not give Joe cash. Instead they write Joe a check which Joe deposits in Bank A or any other bank. Total deposits have increased $850 to $1,850, Julie's initial $1,000 plus Joe's loan proceeds of $850. The increase in the amount deposited ($850) increases the money supply because demand deposits are considered part of the money supply. Assume Joe deposits his $850 in Bank B. Bank B retains $127.50 in reserves, and lends out $722.50. The $722.50 is deposited in another bank. This bank retains $108.38 and lends out $614.12. The cycle continues. The table below summarizes the growth of the money supply for ten transactions when each bank retains 15 percent of its deposits in reserve. Note that the money supply increase is less after each transaction. It also does not matter which bank receives the deposited money. In each case, 15 percent is retained for reserves and 85 percent of the deposit is loaned.
Most nations use fractional reserve banking. A central bank sets a reserve requirement, which establishes the minimum reserves a bank must hold. The reserve requirement is one of the tools the central bank has to manage the money supply. A higher reserve requirement restricts the growth of the money supply.
The maximum increase can be calculated using the formula:
Maximum Increase in Money Supply = 1 / Reserve Requirement
The risk of a fractional reserve banking system occurs when panic creates a bank run. News spreads quickly when a bank does not hold enough reserves to meet withdrawal requests from its customers. Soon everyone would demand their money out of fear of losing it. This is the reason for safeguards such as deposit insurance and the central bank acting as the lender of last resort.