Fractional-Reserve Banking

Fractional-reserve banking makes it possible for banks to pursue two activities simultaneously: (1) safely maintaining the liquidity of checkable deposits and a portion of the money supply and (2) acting as a financial intermediary to match up lenders (especially households depositing paychecks) and borrowers (especially businesses investing in capital goods).

The practice of fractional-reserve banking means that banks must balance the profitability of loans with the safekeeping of deposits. Tilting too far in the direction of loans jeopardizes the safety of deposits. Excessively emphasizing safekeeping limits profit. In either case, problems can emerge and banks can go out of business if a proper balance is not maintained.

Making Loans, Making Money

This financial intermediary lending process has two notable consequences.

• First, like other financial intermediaries, banks often accumulate pools of funds from their depositors, which are then used for large volume loans. Such lending activity allows businesses to invest in large scale projects. Not only does the production of the resulting capital generate employment and income, but it also expands the long-run production capacity of the economy. AmosWEB National Bank, for example, might combine a few hundred dollars each from a couple of thousand depositors, which it then uses for a multimillion dollar loan to OmniComglomerate, Inc. to construct a new shoelace factory.


• Second, when banks make loans with excess reserves they do so by increasing checkable deposits, which adds to the economy's money supply. In fact, the Federal Reserve System controls the money supply by adjusting the amount of excess reserves held by banks. When they want an increase in the money supply, they increase excess reserves. When they want to decrease the money supply, they decrease excess reserves. If, for example, AmosWEB National Bank has $20,000 of excess reserves, then it is can make a loan to Duncan Thurly for the purchase of a new OmniMotors XL GT 9000 Sports Coupe. Duncan receives the money for this loan, when AmosWEB National Bank adds $20,000 to Duncan's checking account.

Legal and Required

• Legal Reserves: Legal reserves are simply the total amount vault cash and Federal Reserve deposits held by banks. While banks have a number of different assets that could, in principle, be used as reserves to back bank deposits, vault cash and Federal Reserve deposits are the only assets that are permitted by government regulations.


• Required Reserves: Required reserves are the amount of reserves--vault cash and Federal Reserve deposits--that regulators require banks to keep for daily transactions. Required reserves are specified as a fraction of outstanding deposits--usually about 1 to 3 percent.