when you deposit money in your savings account your bank can use an amount specified as capital to fund loans and pay you for using your money for instance say you deposited 2 000 in a savings account savings accounts pay interest generally between 0 5 and 2 so you receive an interest payment on your money and the bank can use part of it in a loan in turn the bank might want to access 80 of your money to use as loans to other customers 
you receive interest as an incentive for keeping money in an account the bank can use to create loans the federal reserve sets interest rates they are based on economic circumstances and how it decides it can best meet its dual mandate of maximum employment and price stability if a bank needs capital to fund loans withdrawals pay debts or meet other obligations it can borrow from other banks and pay them interest as a last resort the federal reserve maintains a service called the discount window where it lends money to banks at a higher interest rate than they charge between themselves 1 this encourages banks to seek funds from each other rather than the fed interest is charged between financial institutions based on a range set by the federal reserve board of governors called the federal reserve target rate range the average interest rate banks charge each other is referred to as the effective federal funds rate fractional reserve banking processthe fractional reserve banking process creates money that is inserted into the economy when you deposit that 2 000 your bank might lend 90 of it to other customers along with 90 from five other customers accounts this creates enough capital to finance 9 000 in loans your balance still reflects 2 000 and the customers that the bank borrowed from also see their balances remain unchanged if all five customers have account balances of 2 000 it will look something like this history of fractional reserve bankingfractional reserve banking supposedly has its roots in an era when gold and silver were traded goldsmiths would issue promissory notes which were later used as a means of exchange the smiths used the deposited gold to issue loans with interest and fractional banking was born in the u s the national bank act was passed in 1863 to require banks to keep reserves on hand to protect depositor funds from being used in risky investments 2 in 1913 the federal reserve act created the system of federal reserve banks we now know collectively as the federal reserve system banks were required to keep reserve balances with the federal reserve banks 3reserve requirements for banks under the federal reserve act were set at 13 10 and 7 depending on the type of bank in 1917 in the 1950s and 60s the fed had set the reserve ratio as high as 17 5 for certain banks and it remained between 8 to 10 throughout much of the 1970s through the 2010s 4during this period banks with fewer than 16 3 million in assets were not required to hold reserves however banks with fewer than 124 2 million in assets but more than 16 3 million had to have a reserve size of 3 and those banks with more than 124 2 million in assets had a 10 reserve requirement 5on march 26 2020 the 10 and 3 required reserve ratios against net transaction deposits were reduced to 0 for all banks essentially removing the reserve requirements altogether 5 it was replaced with interest on reserve balances iorb or interest paid on reserves the banks hold as an incentive rather than a requirement 6fractional reserve banking vs other types of bankingmost countries today use fractional reserve banking because it is not feasible to use 100 reserve banking moreover a system that requires banks to hold 100 of deposits cannot create more money without devaluing its currency thus banks would need to hold a significant amount of capital to issue loans this would greatly reduce growth in developing and developed economies because the banks could not issue debt to businesses and consumers that rely on it for large purchases and investments a system backed by precious metals such as gold is also prone to this problem if a specific amount of a country s currency has to be represented by a certain amount of gold the country is limiting its growth potential because there is a finite amount of gold available to meet the growing demand for capital the currency s value would continuously be reduced fractional reserve banking allows a country to grow its money supply to meet the demand for growth advantages and disadvantages of fractional reserve bankingbanks don t need to hold vast amounts of capitalbanks stimulate the economy by lendingallows for macroeconomic regulationconsumer panic can cause mass withdrawals and lack of capitaltoo much lending can cause the economy to overheatcriticisms of fractional reserve bankingthe one main criticism of fractional reserve banking is that there are insufficient funds for everyone to withdraw at once however this is generally not an issue because people won t need to remove all of their capital under most circumstances before the introduction of the fed in the early 20th century the national bank act of 1863 imposed 25 reserve requirements for u s banks under its charge this can be witnessed by reviewing the greek financial crisis that began in 2009 in 2015 greece defaulted on its debts to the international monetary fund amidst a global financial crisis as a result citizens flocked to the banks to withdraw their funds and the banks were forced to close their doors to prevent a complete withdrawal of capital from a struggling system further back in time at the start of the great depression in the u s consumers rushed to banks to withdraw all of their funds leading to the collapse of new york s bank of the united states 