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Fractional Reserve Banking

Fractional-reserve banking is the most popular form of commercial banking, in which the bank is permitted to lend or invest nearly all of the capital that was deposited in the institution; this means that only a tiny, fractional amount of the total deposits are actually backed by cash and available for withdrawal at a given time. The small fraction of deposits that a bank is not permitted to loan or invest, known as the reserve ratio, is mandated by the U.S. Federal Reserve System, or the central bank in other countries.

A reserve ratio is mandated because commercial banks will generally lend out as much money as possible to maximize revenue through interest payments or maximize return on investment or yield. To counteract the incentive to lend and invest aggressively, governments and central banks mandate a proportion of funds that a commercial bank must maintain. In reality, required reserve ratios are now at 0% which means that banks do not have to maintain a minimum reserve ratio any longer.

Following the financial crisis of 2007-2009, the Federal Open Market Committee (FOMC), the main policymaking body of the Fed, lowered the federal funds rate target to near zero. The decision to lower the federal funds rate increased the quantity and amount of reserves held by the Fed on behalf of commercial banks. Accordingly, slight adjustments to the supply of reserves are no longer a practical or effective monetary policy for adjusting the federal funds rate. On March 15, 2020, the Federal Reserve reduced reserve requirement ratios to zero percent and transitioned to an “Ample-Reserves Regime” to eliminate the need for active management of the supply of reserves.

Learn more about monetary policy in an Ample-Reserves Regime.