Fractional Reserve Banking
A banking system in which banks hold only a fraction of deposits in reserve and lend the rest.
What is Fractional Reserve Banking?
Fractional reserve banking is the standard banking system in which commercial banks are required to hold only a fraction of their customer deposits as reserves and can lend out the remainder. This system allows banks to create money through lending: when a bank lends $900 of a $1,000 deposit, the $900 becomes a new deposit somewhere in the banking system, which can then be partially re-lent, and so on — creating a money-multiplying effect. The total amount of deposits created from an initial injection of reserves is limited by the reserve ratio. Fractional reserve banking makes credit widely available and drives economic growth, but it also makes banks inherently vulnerable to bank runs if many depositors withdraw at once.
Example
With a 10% reserve requirement, a $1,000 initial deposit theoretically allows the banking system to create up to $10,000 in total deposits (money multiplier = 1/0.10 = 10). In practice, the multiplier is lower because banks hold excess reserves and not all lent money returns as deposits.
Source: Federal Reserve Bank of Chicago — Modern Money Mechanics