Fractional reserve banking is a system in which only a fraction of bank deposits are backed by actual cash on hand and available for withdrawal. This is done to theoretically expand the economy by freeing capital for lending.
Banks are required to keep on hand and available for withdrawal a certain amount of the cash that depositors give them. If someone deposits $100, the bank can’t lend out the entire amount. Nor are banks required to keep the entire amount on hand. Many central banks have historically required banks under their purview to keep 10% of the deposit, referred to as reserves.
Fractional reserve” refers to the fraction of deposits held in reserves. For example, if a bank has $500 million in assets, it must hold $50 million, or 10%, in reserve. Fractional reserve banking has pros and cons. It permits banks to use funds (the bulk of deposits) that would be otherwise unused to generate returns in the form of interest rates on loans—and to make more money available to grow the economy. It also, however, could catch a bank short in the self-perpetuating panic of a bank run.