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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.
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.
Reserve requirements are the primary way central banks control the amount of money supply to hold down inflation, while providing a cushion for operational risk by banks. Ahh, but here's the rub: a bank initially capitalized for $500 billion (to guarantee depositors money) may after 10 years in business be holding $2 trillion in deposits without increasing its capitalization. Only the reserve requirements are mandated to increase, the rest being offset by the FDIC.
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 withdrawals 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.
Although "reserve requirement" is a common introduction to fractional reserve banking, some countries have no mandatory reserve requirement. In such countries the amount of money that banks hold as reserves is determined by the banks themselves, which have to have at least some cash on hand in order to handle withdrawals. The list of countries without a reserve requirement includes that far-right libertarian bankster paradise known as Canada. However, those countries also have several additional mechanisms that in essence serve the same function reserve requirement would.
Some countries that have reserve requirements, such as China, use them to manipulate the size of the money supply. Lowering the reserve requirement allows banks to lend more, ideally stimulating the economy; raising it makes banks lend less, ideally lowering inflation. Other countries with reserve requirements, such as the United States, rarely change the reserve requirement and primarily manipulate interest rates to stimulate the economy and control inflation.
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 which can be supplied by the central bank in time of need. 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 demand-pull inflation.
Due to the stability of the modern day banking system, banks can create new loans without giving much regard towards their reserves. If they find out they need more, they can lend on an interbank market (FED funds, LIBOR), which gives reserves to banks who need it. [note 1] But these loans come with interest, so the only way bank is going to do it is by lending it at a higher rate, and only if someone is actually willing to take on that debt.
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 Brooks' 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 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 has traditionally been policy favored mostly by Scrooge McDuck, and Austrians, but has gained currency in certain circles following the 2008 crash, and has been advocated by economists Laurence Kotlikoff, John Kay and John Cochrane as well as the Financial Times' chief economics commentator Martin Wolf, and Iceland look to be heading towards implementing full reserves.
Lord Adair Turner, formally the UK's chief financial regulator, said "Banks do not, as too many textbooks still suggest, take deposits of existing money from savers and lend it out to borrowers: they create credit and money ex nihilo – extending a loan to the borrower and simultaneously crediting the borrower’s money account". Money created this way cannot be used to save any bank from bankruptcy, but it's still called money.
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.
The multiplier effect, or money multiplier, refers to the effects of a bank lending 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. The resulting amount of money is 1/x multiplied by an original deposited amount, where x is the required reserve ratio in decimal form. For example, a bank is required to have a 20% reserve. Alice deposits her $1000 paycheck into the bank. The bank is able to lend out $800 to Bob, who buys a used car from Charlie, who deposits the $800 into another bank. The bank turns around and lends $640 to Denise, and so on down the line until there is $5000 in the system.
While it may seem a bit like smoke and mirrors to someone unfamiliar with economics, imagine instead of cash it was something with 'obviously' more use such as tools. We all need tools to work, but the vast majority of time we own the tool we aren't using it. So we put the tools in a tool bank, so that others can use it while we are not. If we only need the tools for about 20% of the time, the result is that the bank causes there to be effectively 5 times as many tools in the system. That it's currency instead of tools doesn't change the effect.
The multiplier effect is generally regarded as a simplification in academic and policy making circles. The Bank of England has stated that "while the money multiplier theory can be a useful way of introducing money and banking in economic textbooks, it is not an accurate description of how money is created in reality", and the multiplier model "has not featured at all in the recent academic literature". Charles Goodhart, the UK’s pre-eminent monetary economist and former member of the Bank of England's Monetary Policy Comittee has stated that “as long as the Central Bank sets interest rates, as is the generality, the money stock is a dependent, endogenous variable. This is exactly what the heterodox, Post-Keynesians ... have been correctly claiming for decades, and I have been in their party on this.” 
In the Post-Keynesian view, 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)[note 2] 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 affect 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 and insurance companies loaded with potential risk and liabilities.
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.
The United States is the only country in the world to have ever imposed the segregation of consumer banking and investment banking which existed under Glass-Steagall.
- Investopedia definitions of relevant concepts: fractional reserve banking, reservable deposit, multiplier effect, money supply
- Extremists exploit financial crisis, ADL
- Does the money multiplier exist?
- 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.
- Those guys are really against fractional reserve banking? I really didn't expect that these guys want to destroy capitalism.
- Implementation of Monetary Policy in a Regime with Zero Reserve Requirements
- China Cuts Banks' Reserve Requirement Ratio
- Federal Reserve: Reserve Requirements
- 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.