Question

Why banking system is said to be on fractional reserve.

Answer 1

Fractional reserve banking is a mechanism in which only a fraction of bank deposits are backed up and available for withdrawal by real cash on hand. It is achieved to boost the economy potentially by freeing up lending money.

Banks are allowed to keep a certain amount of the cash that depositors send them on hand, but banks are not required to keep all the cash at hand.
Most banks are expected to maintain 10 per cent of the reserve deposit.
Some banks are exempted from keeping reserves but a rate of interest on reserves is charged to all banks.

It is a feature of banking business that banks are allowed to hold just a fraction of the funds deposited with them on hand. Banks borrow funds from their depositors (those with savings) and in exchange lend those funds to lenders from the banks (those who need money). Banks make money by charging lenders more for a loan than is charged to depositors for the use of their money (a higher percentage interest rate). If banks failed to lend their available funds after meeting their reserve requirements, depositors might have to pay banks for their money to provide safekeeping services. The practice of keeping only a fraction of deposits on hand has an significant cumulative impact for the economy and for the banking system as a whole. Called the fractional reserve system, this allows the banking system to "make" capital.