Fractional Reserve Banking

The principle of fractional reserve banking lies at the heart of the modern commercial banking system. During a given period of time a bank will receive fresh deposits while existing deposits are withdrawn. Normally the fresh deposits and the withdrawn deposits cancel each other out. Despite daily deposits and withdrawals, a bank maintains an average level of deposits that represents funds the bank can largely keep loaned out. For safety banks hold back a certain fraction of deposits, called reserves (thus fractional reserve banking), to cover themselves over periods of time when withdrawn deposits exceed fresh deposits. Because these reserves earn no interest, banks are tempted to cut the margin of reserves a bit thin. If adequate, these reserves enable a bank to weather a crisis of confidence when masses of people suddenly withdraw deposits out of fear.