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Fractional-reserve banking refers to a banking system where the bank holds a fraction of the demand deposits it receives, and loans out the rest. It is the primary mode of operation of nearly all retail banks in the modern world.
The very thought that a bank may do something other than sit in front of your money and watch it grow mold makes some people foam at the mouth. Many get very quiet if you ask where the interest on their liquid savings accounts would come from then.
The same people often howl that government intervention in the banking system is filthy socialism because it is not their favored economic policy. Safe to say this is often ignoring history, when before there was regulation of fractional reserve banking by the Federal Reserve things were much more exciting for depositors, what with all the constant banking crises and all.
 The Basics
It is relatively simple to start with. A bank must hold a certain amount of cash on hand from customer deposits, known as a "reserve requirement" regulated by the central bank, and loan out the remainder to generate revenue for the bank and depositors by charging interest on loans of that money. This is a primary way central banks control the amount of money supply to control inflation, while providing a cushion for operational risk by banks.
 The Good
This is very good in keeping cash around as banks would like to loan out as much money as they can supposedly without unnecessary risks, keeping only the cash on hand they might need in a day. If there is an excess of the amount of money people demand as withdrawls in a day, and the bank cannot come up with the money, the bank falls below its reserve requirement and faces a liquidity squeeze . A run on the bank could be triggered if people perceive the bank may not have enough currency in the vault to cover the cash in their accounts. This happened to many small banks in the US before the Federal Reserve was introduced, causing numerous bank failures and financial panics when banks could not come up with the cash to satisfy depositor's demands immediately. This also limits risks that the depositor's insurance (FDIC) would kick in every time one too many people come into the bank and ask for cash.
Being able to loan out money is also in many people's favor. This way loans can be made by the combined accounts of many depositors, instead of having a few very wealthy people make personal loans. Most Americans would not have home loans or employers meet payrolls without fractional reserve banking. It has incentive, by paying interest, to keep money in banks so they may generate loans.
It is a great way to control inflation, by mandating the money available to make loans. Fewer loans will reduce the supply of money available and increase interest rates by commercial banks, although central banks do not manipulate it often, as changing reserve requirements are equivalent to taking a sledgehammer to the economy.
 The Bad
While banks can't literally print their own money in a system with a central bank, they can increase the money supply. In a system of fiat currency, banks' monetary base (i.e., what is actually in the "vaults") is made up of money backed by the central bank. However, when banks make loans above their reserve (which is pretty much always), it adds to the money supply, specifically what economists call "M2" and "M3" (depending on the type of loan), which are considered less "liquid" than the monetary base. Thus, lending can (but not necessarily will) cause inflation.
In the world of electronic banking, banks can now create "money" out of thin air, through create accounts. When someone spends these accounts, they are transferred to another bank, then this is lent on an interbank market (FED funds, LIBOR), to give reserves to banks who need it. 
It is always possible to still get a run on the bank if too many people demand money in excess of the reserve. A simple analogy is airline seating. Airlines know a few people will cancel, so they overbook flights by selling more tickets than seats. A run on the bank is like everyone showing up to the flight and no cancellations. (Or the plot of Mel Brook's The Producers, when the play they'd over-sold shares of unexpectedly became a hit.) Bank runs are prevented in modern banking systems by the creation of a lender of last resort[wp] to avoid short-term liquidity shortfalls.
The fractional reserve system itself takes no account of the risks of the loans banks make. If the reserve requirement was set to 100%, interest accumulated in deposits and the generation of loans would be nearly nonexistent. However, no banks would run out of money, as long as they had absolutely no costs. This is a favored policy of Scrooge McDuck, and Austrians.
 The Conspiracy Theories
Fractional reserve banking is the subject of numerous conspiracy theories. They usually revolve around or have their roots in anti-Semitism in the form of Jewish banker conspiracies like the Rothschild family controlling the world. This usually ties in to conspiracies about the Federal Reserve as well as gold buggery or sound money. Sometimes the cry of "fractional reserve banking is fraud!" is a cover for some kind of economic woo or scam — usually of the "don't trust banks, put your money in my Ponzi scheme instead" variety. Sometimes these theories are just the result of people failing to understand abstract concepts.
 Multiplier effect
The multiplier effect, or money multiplier, refers to the ability of a bank to lend money over its reserve requirements as explained above. By law, banks are required to keep x% (depending on the locale and type of bank) of the total money they lend out in reserve. However, some economists, usually of the Post-Keynesian school, argue that the multiplier is an ex-post facto accounting identity (or, in other words, a legal fiction). The reason for this is that a bank can make any loan it deems worthy and then borrow money from either the interbank loan market (a market in which banks lend excess reserves to each other) or the Fed discount window to meet reserve requirements.
 Bank capitalization, charters, and the Glass-Steagall Act
Banking regulation is much stricter than regulation in other industries and the financial sector. To apply for a bank charter, the owners (usually bank holding companies) of the bank's capitalization are required to be debt free. Banks are supposed to be unencumbered rock solid investments. Once the charter is granted the bank then can receive deposits, i.e., a debt owed to depositors encumbered by the bank's capitalization. The combined value of the banks capitalization, along with its ability to lend other peoples money (depositors money) equals the bank's balance sheet.
If a part owner of a bank holding company were to take on private debt, and sold his stake in the bank to satisfy the debt, that could reduce the bank's capitalization, drive down the value of other shareholders stake, curtail the bank's ability to lend, and effect the economic growth and activity in the surrounding neighborhood. Thus holders of bank charters are strictly regulated and supposed to be responsible with a proven track record in managing their own financial affairs.
The Glass-Steagall Act strictly regulated bank's and bank charter owners ability to use bank assets (i.e., a bank's capitalization, depositor's money, and earnings from its capitalization and depositors money). Under Glass-Steagall banks were limited to collecting interest off of lending depositors money (which a portion was paid back to depositors) or brokering deals -- bringing buyer and seller together and making a fee off the transaction without using the bank's own cash. Repealing Glass-Steagall opened the door to proprietary trading -- removing the heretofore strict requirements of banks to only invest or engage in the most conservative activities, and allowing them to purchase with bank stock and earnings, riskier assets with potentially more lucrative return, such as sub-prime mortgages.
The Volcker Rule, named after former Federal Reserve Chairman Paul Volcker and part of the Dodd-Frank Fin Reg bill aimed at Wall Street reform, is an effort to allow the Federal Reserve stricter oversight of bank holding companies ownership and activities, which is difficult due to confidentiality agreements and privacy rights.
- Investopedia definitions of relevant concepts: fractional reserve banking, reservable deposit, multiplier effect, money supply
- Extremists exploit financial crisis, ADL
- Does the money multiplier exist?
- ↑ Those guys are really against fractional reserve banking? I really didn't expect that these guys want to destroy capitalism.
- ↑ Commercial banks by far create more new money daily by interbank lending than the Federal Reserve does. Depositing loan proceeds drawn on one bank with another bank creates new money (the same money appears as an asset on both bank's ledgers). The daily reconcilation of accounts between banks - cashing checks drawn on each other's accounts, and banks with surplus deposits helping a bank with a lot of loan activity in one day causing it to fall below reserve requirements, also affects interbank lending, See here Note 7.
- ↑ In Great Britain interbank borrowing is done at the LIBOR rate. In the United States, commercial interbank borrowing to meet reserve requirements is done at the Federal Funds rate, also known as bankers cost of funds.
- ↑ Defintion: bank holding company
- ↑ Bank Holding Company Act. Capital Adequacy Guidelines:Risk-Based Measure. www.fdic.gov
- ↑ Regulation Y Revised, Federal Reserve Bank of San Fransisco.
- ↑ The "Volcker Rule": Proposals to Limit "Speculative" Proprietary Trading by Banks, Congressional Research Service, June 22, 2010.