What is Fractional Reserve Banking? Definition of Fractional Reserve Banking, Fractional Reserve Banking Meaning and Concept

Fractional reserve banking is a banking system in which banks hold a fraction of their customers' deposits in reserves. This fraction is known as the cash ratio.

Under a fractional reserve banking system, banks are not required to hold 100% of their clients' deposits in their reserves. In this way, they can lend a part of the deposits, which allows them to obtain benefits and remunerate savers. This system is based on the assumption that depositors will never withdraw all their money at the same time.

Fractional reserve banking allows a phenomenon called a bank multiplier to occur. The bank multiplier is the expansion effect of the amount of money that occurs when a bank receives a deposit and only keeps a fraction in reserve, lending the rest. By lending the money that is deposited, the bank allows two people at the same time to have the same money. This process is repeated when the loan recipient deposits their money in a bank. This is why the monetary base does not coincide with the monetary aggregates ( M1, M2, M3 …).

Implications of fractional reserve banking

Fractional reserve implies that banks are at constant risk of insolvency as they cannot cope with a massive withdrawal of deposits. When this situation of massive withdrawal of funds occurs, a so-called bank panic occurs.

To mitigate this ongoing risk, the fractional reserve system often relies on a lender of last resort. This lender is responsible for injecting liquidity into banks in difficult situations to avoid bank panics. In most cases the lender of last resort is the state through the central bank. It is the same central bank that sets what percentage of deposits a bank must keep in its reserves. This percentage is called cash reserve ratio, and is one of the mechanisms of monetary policy of central banks available.