Fractional reserve banking is the most common form of banking practiced by commercial banks worldwide. It involves banks accepting deposits from customers and making loans to borrowers, while holding in reserve an amount equal to only a fraction of the bank’s deposit liabilities. This is done to theoretically expand the economy by freeing capital for lending.
Bank reserves are held as cash in the bank or as balances in the bank’s account at the central bank. The minimum amount that banks are required to hold in liquid assets is determined by the country’s central bank, and is called the reserve requirement or reserve ratio. Banks usually hold more than this minimum amount, keeping excess reserves.