Fractional reserve banking is a system used by banks in which they are required to hold only a portion of the money deposited with them as reserves. The banks use customer deposits to make new loans and award interest on the deposits made by their customers. The reserves are held as balances in the bank’s account at the central bank or as currency in the bank. The reserve requirement allows commercial banks to act as intermediaries between borrowers and savers by giving loans to borrowers and providing immediate liquidity to depositors who want to make withdrawals.

Fractional reserve banking allows banks to essentially create money in the economy. Banks can lend out deposits with interest to amplify the economy, making cash more available to those who need it. Through these loans, banks collect fees and interest, growing returns to fund new loans. Fractional reserve banking permits banks to use funds that would be otherwise unused and idle to generate returns in the form of interest rates on new loans, and to make more money available to grow the economy.

Fractional reserve banking predates the existence of governmental monetary authorities and originated with bankers realization that generally not all depositors demand payment at the same time. In the past, savers looking to keep their coins and valuables in safekeeping depositories deposited gold and silver at goldsmiths, receiving in exchange a note for their deposit. Fractional-reserve banking allows banks to provide credit, which represents immediate liquidity to borrowers. The banks also provide longer-term loans and act as financial intermediaries for those funds.

Most large economic systems today use fractional reserve banking to stabilize and grow their economies. The Federal Reserve regulates bank-credit creation, imposing reserve requirements and capital adequacy ratios. The Feds use of the fractional reserve system has evolved over the past 30 years in parallel with other major free-market economies. Given the complexity of the U.S. system, the current risk-based approach with bank requirements for capital and liquidity to limit how much leverage banks can take on is more effective than a system primarily focused on reserves or reserve requirements.