Lesson: What is fractional reserve banking?

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Fractional reserve banking is a system in which banks are required to hold only a fraction of their customers' deposits in reserve, typically as cash or deposits with the central bank, while lending out the majority to borrowers.

This practice allows banks to expand the money supply through the creation of new loans and deposits, facilitating economic growth by making credit more accessible.

For example, if the reserve requirement is 10%, a bank with $100 in deposits can lend out $90, and when that $90 is redeposited elsewhere, it can generate further lending in a multiplier effect.

However, this system carries risks, such as bank runs if too many depositors withdraw funds simultaneously, potentially leading to liquidity crises.

To mitigate these risks, governments and central banks impose regulations, like reserve ratios and deposit insurance, to ensure stability in the banking sector.