Fractional Reserve Banking

Fractional reserve banking is a system where banks keep only a small portion of customer deposits as cash on hand and lend out the majority. This means that if everyone wanted to withdraw their money at the same time, the bank wouldn’t have enough physical cash to cover all accounts. The portion of deposits that must remain on hand—called the reserve ratio—is set by a country’s central bank, such as the U.S. Federal Reserve.

Banks are generally motivated to loan out as much as possible to earn interest. To prevent excessive risk and to keep the banking system stable, central banks historically required banks to keep a certain percentage of deposits in reserve. However, as of March 15, 2020, the Federal Reserve reduced the required reserve ratio for U.S. banks to zero. This means banks are no longer legally required to hold any minimum amount in reserve.

This shift in policy followed the 2007–2009 financial crisis, after which central banks adopted new strategies to influence lending and interest rates. Instead of adjusting reserve requirements, the Federal Reserve now uses tools like setting interest rates on excess reserves to guide monetary policy. This approach is known as the “Ample-Reserves Regime.”