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.

Vault Cash

The most important function of vault cash is, quite literally, to "cash" checks and otherwise to satisfy currency withdrawal demands of depositors. Even as the economy relies more on paper checks, debit cards, and electronic transfers, currency (paper bills and metal coins) continues to represent an essential medium of exchange. As such, the public is inclined to transfer wealth between bank deposits and currency. Banks must stand ready to complete this transfer with stockpiles of paper bills and metal coins.

Note that vault cash is not part of the official M1 money supply. M1 includes only the paper bills and metal coins that is in circulation and held by the nonbank public. Vault cash is paper bills and metal coins that is held by banks and thus it is not in circulation.

Federal Reserve Deposits

These 37 Federal Reserve Banks provide a number of banking services to commercial banks, including loans and deposits. If the public seeks loans or deposits, they can go to a commercial bank. If a commercial bank seeks loans or deposits they can go to a Federal Reserve Bank.

Federal Reserve deposits play at least two key roles in the banking system.

• First, commercial banks are legally required to keep a deposits with the Federal Reserve Banks to join the system. These deposits are effectively the price of admission, the dues that commercial banks pay to be a full-fledged member.


• Second, Federal Reserve deposits are essentially the medium of exchange used internally within the banking system. When banks make payments among each another or with Federal Reserve Banks, they do so using Federal Reserve deposits. The most important payment made between banks results when checks are processed. The process of "clearing" checks invariably requires the transfer of reserves between banks, which is accomplished using Federal Reserve deposits.

Required and Excess

• 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.


• Excess Reserves: Any legal (or total) reserves over and above those required by regulators are excess reserves. These excess reserves are used for loans, which makes them exceedingly important to the banking industry. Because reserves, unlike loans, do not generate interest, add to revenue, or enhance profit, banks are prone to hold as few reserves as possible. Banks hold enough reserves to satisfy reserve requirements, because they are required by law. But they try NOT to hold excess reserves. Holding excess reserves means lost interest revenue.