Fractional reserve banking is the standard method of banking in our modern world, but few understand what it really is. At best there might be some vague understanding of how banks operate and make money, but there is little total comprehension. To understand fractional reserve banking, however, one must first understand a little of the history of banking.
Banking — or, perhaps, ‘proto-banking’ — in the sense of storing money or proto-money is very nearly as old as civilization itself. In the days of ancient Babylon, enormous temples would have mounds of silver, used as units of accounting (rather than as true currency), buried in their depths. Other ancient civilizations had similar systems. For convenience, instead of moving around the silver every time transactions were made (the selling of barley at harvest-time, for example) the silver would be kept collectively and accounts would be held and manipulated. Proto-banking indeed.
When real money was invented — not merely units of account but taxable units with fiduciary value — banking was pressured to evolve. Rather than the enormous centralized systems centered upon a single city of the early days of civilization, civilizations were suddenly much more spread out. People were much more inclined to want their money, rather than be content with the temple agents enabling transactions between two residents of the single city. They might wish to move to another city or live out in the hinterlands, and suddenly centralized temple proto-banks with elaborate account systems were no longer feasible.
Enter banking. Originally just a natural evolution of the proto-banks of ancient days, banks were formed for the same purpose. Just as civilization had decentralized, so did banks, but the purpose remained the same: a collective storage of money for security. One’s money would be protected better than one could protect it oneself. Of course, like any business this was not done for free. One would be charged a fee for having one’s money protected, but bankers quickly discovered a better way of doing business.
Bankers noticed that withdrawals — people wanting their money out of the bank — were comparatively rare. Most of the time, large amounts of money sat unused within the bank’s vaults. So, they thought, perhaps it could be put to use. This is where modern banking was born. Instead of merely guarding money, bankers decided to start ‘loaning’ the money out in order that they could make more money. As a bonus, this meant that instead of charging depositors fees for the storage and protection of their money bankers could instead offer them interest payments for the use of their money.
This system, in its entirety, is fractional reserve banking. It is straightforward to understand and explain. The bank has some amount of money it does not ‘loan’ out. This is the ‘reserve.’ It is money not at risk. At the same time, it has some amount of money that is nominally stored in the bank — that is, all the depositors of the bank have given them some amount of money that they expect to get back at any time. Since the bank has given out some of this money, its reserve is actually less than what they are supposed to be storing. It is a fraction of their supposed total amount. That is, it is a fractional reserve, hence ‘fractional reserve banking.’
To finish off, it must be pointed out that non-fractional reserve banking is actually more complicated than opponents of FRB imagine. In order to not have a fractional reserve, one must have all the money one is nominally storing for account-holders on hand. However, if a bank is storing all the money it is given, how is it supposed to make money? Either it must loan out some other money (likely its own or those of other (explicit) investors) or it must begin charging depositors fees. Either way, depositors can no longer rightly expect to receive money on their accounts, since their money is no longer at risk.