The United States has a reserve banking system. Banks maintain cash reserves that amount to only a fraction of their deposit liabilities (what they owe to their customers).

Note: To understand the concept of "fractional reserve banking" it does not matter where the bank keeps its reserves. For the sake of this explanation, they could even keep their reserves in their own vault. They do, however, maintain a deposit account for reserves with the Federal Reserve bank.

Reserve Ratio

The fraction of the money commodity held in "reserve" we call the reserve ratio. If the reserve ratio equals 50%, the reserves amount to half the deposit liabilities. If the reserve ratio equals 8%, the reserves amount to 8% of the deposit liabilities.

Demand Deposits vs. Time  Deposits
(Or Transaction Accounts vs. Non-transaction  Accounts)

Bank reserves get a little confusing because demand deposits and time  deposits (now referred to as transaction accounts and non-transaction  accounts respectively) have different reserve requirements. Time deposits have historically had lower reserve requirements, because depositors did not have ready access to those funds like they did with their demand deposits.

The lower reserve requirements for time  deposits have become more significant with the advent of bank checking alternatives, like money market mutual funds.

Required Reserves

The Required Reserves equal a bank's total deposits multiplied by the reserve ratio for each deposit category. The bank must have balances in their reserve accounts of no less than their Required Reserves.

Actual Reserves

We call the actual amount of reserves in account the Actual Reserves.

Excess Reserves

Excess reserves equal Actual Reserves less Required Reserves. Excess reserves determine the current money creating capacity or credit potential of the bank (or the banking system.) I will explain in a moment.

Credit Potential

We can determine the current money creating capacity or credit potential of the bank by dividing excess reserves by the reserve ratio. A bank with a reserve ratio of 10% and $1,000,000 in excess reserves has the credit potential of $10,000,000. (Credit potential actually applies system wide, to the whole banking system.)

In a banking system that uses fractional reserves, money creating (or credit) potential varies dramatically with changes in the reserve ratio.