Fractional-reserve banking

Fractional-reserve banking is a system where banks that accept deposits from the public hold only a portion of those deposit obligations in liquid form as reserves, lending out the rest to borrowers. This lending expands the money supply by the amount loaned. Bank reserves consist of cash held in the bank or balances in the bank’s account at the central bank. This system contrasts with the hypothetical full-reserve banking model, where banks would keep all deposited funds on hand as reserves.

A central bank may set a minimum reserve requirement or ratio, though most commercial banks hold more than this minimum as excess reserves. Some countries—including the United States, the United Kingdom, Canada, Australia, New Zealand, and the three Scandinavian nations—do not impose explicit reserve requirements at all. Bank deposits are typically short-term, often available on demand, while loans tend to be longer-term. This mismatch creates a risk that depositors might collectively try to withdraw more cash than the bank holds in reserves. Reserves are meant to cover normal withdrawal patterns; banks and central banks expect only a fraction of deposits to be withdrawn at once. If a shortfall occurs, a bank can borrow short-term funds from other banks in the interbank lending market. In exceptional cases, such as a bank run, the central bank may act as lender of last resort to cover the shortfall.

Because banks hold less in reserves than their deposit liabilities, and because those deposits are themselves considered money (commercial bank money), fractional-reserve banking allows the money supply to grow beyond the base money originally created by the central bank. Most central banks regulate credit creation through reserve requirements and capital adequacy ratios to ensure solvency and liquidity, and to influence money creation. However, contemporary central banks typically target interest rates rather than directly controlling the money supply to manage credit issuance and inflation.

**History**

Fractional-reserve banking predates government monetary authorities. It began when goldsmiths, who stored gold and silver for safekeeping, issued notes as receipts. These notes became a medium of exchange, an early form of paper money. Goldsmiths noticed that not all note holders redeemed them at once, so they lent out their coin reserves in interest-bearing loans and bills, earning income. This shifted their role from passive guardians charging storage fees to interest-paying, interest-earning banks, giving rise to fractional-reserve banking. However, if creditors lost faith in a bank’s ability to pay, many would redeem notes simultaneously. If the bank could not raise funds by calling in loans or selling bills, it would become insolvent or default—a bank run that doomed many early banks.

These crises led to the creation of central banks. The Swedish Riksbank, founded in 1668, was the first. Many nations followed in the late 1600s, establishing central banks with legal power to set reserve requirements and specify the form of monetary base assets. Central banks also centralized precious metal reserves to ease gold transfers during runs, regulated commercial banks, and acted as lenders of last resort. This reduced the risk of bank runs inherent in fractional-reserve banking, allowing the system to persist as the prevailing banking model worldwide. In the twentieth century, central banks expanded their role to manage macroeconomic variables like inflation, unemployment, and balance of payments, often using interest rates, reserve requirements, and measures of the money supply and monetary base.

**Regulatory framework**

In most legal systems, a bank deposit is not a bailment. The deposited funds become the property of the bank, not the customer. The customer receives a claim against the bank for the amount deposited.