What is fractional-reserve banking?
A banking system in which a bank only keeps a small amount of the money deposited on hand for withdrawal. The rest is used to make loans or investments.
Where have you heard about fractional-reserve banking?
It’s the most common form of banking currently operating in most countries. You may have specifically heard the term mentioned in discussions on bank bailouts, where a government steps in to enable a bank to meet its deposit liabilities.
What you need to know about fractional-reserve banking...
When you deposit money in a bank, the bank will use a proportion of your deposit to generate more money, through loans and investments. That’s how you can earn interest on your savings. The bank will keep a fraction of its deposits (e.g. 10 percent) as reserves – currency which people can withdraw.
If too many people want to withdraw their deposits at the same time, the demand for cash could exceed the reserves held by the bank. This is called a bank run. If multiple banks experience bank runs at the same time this can lead to a financial crisis.
Find out more about fractional-reserve banking...
To reduce the risk of a bank run, central banks will usually require commercial banks to hold a certain level of reserves to cover possible withdrawals. Find out more about this reserve requirement in our definition.