Fractional reserve banking is a banking system in which banks are required to keep only a fraction of the customer deposits as reserves, while the remainder can be lent out to borrowers. This system allows banks to create money through the process of lending and deposit creation. Fractional reserve banking is the prevailing system used by commercial banks around the world.

Here’s how fractional reserve banking works:

1. **Reserve Requirement:**
– Central banks, such as the Federal Reserve in the United States, set reserve requirements, which specify the percentage of customer deposits that banks must hold in reserve. The remainder, called the “excess reserves,” can be used for lending.

2. **Deposit Creation:**
– When a customer deposits money into a bank, a portion of that deposit is held in reserve, and the rest can be lent out. The deposited amount becomes part of the bank’s reserves, and the bank is allowed to create new money by making loans based on the reserve requirement.

3. **Lending and Money Creation:**
– Banks can lend the excess reserves to borrowers, such as individuals, businesses, or other financial institutions. When the loan is made, the borrower typically receives the loan amount in the form of a deposit in their account. This new deposit becomes part of the money supply.

4. **Multiple Deposit Creation:**
– The process of lending and deposit creation can be repeated multiple times as the newly created deposits are redeposited into the banking system. This cycle continues, leading to a multiplier effect on the money supply. The total money supply in the economy is a multiple of the initial deposit.

– The money multiplier, which is influenced by the reserve requirement, represents how much the money supply can expand for a given increase in reserves.

\[ \text{Money Multiplier} = \frac{1}{\text{Reserve Requirement}} \]

– For example, if the reserve requirement is 10%, the money multiplier is \( \frac{1}{0.10} = 10 \). This means that the banking system can potentially create 10 times the initial deposit through lending and deposit creation.

5. **Risk and Stability:**
– While fractional reserve banking facilitates the creation of money and promotes economic activity, it also introduces risks. Banks must manage their reserves carefully to meet withdrawal demands from depositors. If many depositors attempt to withdraw their funds simultaneously, it can lead to a liquidity crisis for the bank.

6. **Central Bank Oversight:**
– Central banks play a crucial role in overseeing the fractional reserve banking system. They set reserve requirements, conduct monetary policy to influence interest rates and money supply, and act as lenders of last resort to provide liquidity to banks in times of financial stress.

Fractional reserve banking is a key feature of modern banking systems, but it requires careful management to balance the benefits of money creation with the need for financial stability. Central banks play a crucial role in regulating and stabilizing the banking system to ensure its smooth functioning.