Definition
Fractional reserve banking is the system in which commercial banks hold only a fraction of their deposits as reserves — vault cash plus balances at the central bank — and lend out the remainder. A bank that receives a $10,000 deposit does not store that money in a vault; it keeps perhaps $1,000 as a reserve buffer and lends the other $9,000. The borrower spends those funds, which land as deposits in another bank, which again keeps a fraction and lends the rest. Each cycle creates new deposits, multiplying the initial deposit into a larger money supply.
This mechanism is what allows a modern banking system to expand the money supply well beyond the base money created by the central bank. It is also what makes banks structurally vulnerable: they borrow short (deposits that can be withdrawn on demand) and lend long (mortgages, business loans), so a sudden surge in withdrawal demands — a bank run — can destabilize even a technically solvent institution.
Why it matters
The bank run problem
How deposits multiply
The deposit expansion process
When the central bank injects $1,000 of base money into the banking system:
- Bank A receives $1,000 in deposits, holds $100 (10% reserve), lends $900
- The $900 lands in Bank B as a deposit. Bank B holds $90, lends $810
- Bank C holds $81, lends $729 — and so on
The total deposit expansion converges to $1,000 ÷ 0.10 = $10,000 at a 10% reserve ratio. This is the theoretical money multiplier. The base money ($1,000) has been leveraged into a much larger money supply ($10,000) through the lending chain.
Why the multiplier is theoretical
The actual expansion falls short because: depositors hold some funds as cash (leakage from the banking system); banks voluntarily hold excess reserves as buffers (especially during uncertainty); and lending is constrained by borrower demand and creditworthiness, not just reserve availability. After the 2008 financial crisis, US banks accumulated trillions in excess reserves — base money did not translate into proportional money supply growth because lending demand was weak.