Fractional-reserve banking

Fractional-reserve banking is the system of banking in all countries worldwide, under which banks that take deposits from the public keep only part of their deposit liabilities in liquid assets as a reserve, typically lending the remainder to borrowers. Bank reserves are held as cash in the bank or as balances in the bank’s account at the central bank. Fractional-reserve banking differs from the hypothetical alternative model, full-reserve banking, in which banks would keep all depositor funds on hand as reserves.

The country’s central bank may determine a minimum amount that banks must hold in reserves, called the “reserve requirement” or “reserve ratio”. Most commercial banks hold more than this minimum amount as excess reserves. Some countries, e.g. the core Anglosphere countries of the United States, the United Kingdom, Canada, Australia, and New Zealand, and the three Scandinavian countries, do not impose reserve requirements at all.

Bank deposits are usually of a relatively short-term duration, and may be “at call” (available on demand), while loans made by banks tend to be longer-term, resulting in a risk that customers may at any time collectively wish to withdraw cash out of their accounts in excess of the bank reserves. The reserves only provide liquidity to cover withdrawals within the normal pattern. Banks and the central bank expect that in normal circumstances only a proportion of deposits will be withdrawn at the same time, and that reserves will be sufficient to meet the demand for cash. However, banks may find themselves in a shortfall situation when depositors wish to withdraw more funds than the reserves held by the bank. In that event, the bank experiencing the liquidity shortfall may borrow short-term funds in the interbank lending market from banks with a surplus. In exceptional situations, such as during an unexpected bank run, the central bank may provide funds to cover the short-term shortfall as lender of last resort.

As banks hold in reserve less than the amount of their deposit liabilities, and because the deposit liabilities are considered money in their own right (see commercial bank money), fractional-reserve banking permits the money supply to grow beyond the amount of the underlying base money originally created by the central bank. In most countries, the central bank (or other monetary policy authority) regulates bank-credit creation, imposing reserve requirements and capital adequacy ratios. This helps ensure that banks remain solvent and have enough funds to meet demand for withdrawals, and can be used to influence the process of money creation in the banking system. However, rather than directly controlling the money supply, contemporary central banks usually pursue an interest-rate target to control bank issuance of credit and the rate of inflation.

wikipedia/en/Fractional-reserve%20banking

The fractional reserve system is a banking practice where banks are required to hold only a fraction of customer deposits in reserve and can lend out the rest. This practice allows banks to create new money in the economy through lending, a process that expands the money supply. The money multiplier effect occurs because when a loan is made and spent, it is often redeposited into another bank, allowing another portion to be loaned out again.
How it works

Reserve requirement: The central bank sets a reserve requirement, which is the minimum percentage of customer deposits that a bank must keep on hand, either as cash or at the central bank.
Lending: A bank uses the portion of deposits not held in reserve to make loans to individuals and businesses.
Money creation: When a bank makes a loan, it is essentially creating new money. The loaned money is often spent and then deposited into another bank, repeating the cycle and creating more money.

Example

If a customer deposits $1,000 and the reserve requirement is 10%, the bank keeps $100 in reserve.
The bank can then lend out the remaining $900 to another customer.
This $900 is then spent and deposited into another bank, which keeps $90 (10%) and lends out the rest, and so on.

Pros and cons

Pros: The system allows for credit creation, which can stimulate economic growth by providing funds for investment and spending.
Cons: It carries the risk of bank runs, where a loss of confidence could lead to a bank’s inability to meet withdrawal demands, as not all deposits are held in reserve at one time.

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