How Banks Use Your Deposited Money
Understanding fractional reserve banking and the money multiplier effect
What Happens When You Deposit Money?
Your Deposit
When you deposit $1,000 into a bank, you might think the bank keeps all $1,000 in a vault waiting for you. But that's not how modern banking works!
Bank's Perspective
The bank sees your deposit as a liability - they owe you $1,000. But they also see it as an opportunity to make money by lending it out.
The Split
Banks use fractional reserve banking. They keep only a fraction of your deposit as reserves and lend out the rest.
Fractional Reserve Banking
Banks are required to keep only a percentage of deposits as reserves. The rest can be lent out to borrowers. This is called the reserve requirement.
Example: $1,000 Deposit
10% reserve requirement (typical for US banks)
Example: $1,000 Deposit
20% reserve requirement (more conservative)
Example: $1,000 Deposit
5% reserve requirement (less common)
Example: $10,000 Deposit
$10,000 deposit with 10% reserve
Try It Yourself
The Money Multiplier Effect
When banks lend money, borrowers often deposit it back into banks. This creates a chain reaction that multiplies the money supply in the economy.
You deposit $1,000. Bank keeps $100, lends $900
Borrower deposits $900. Bank keeps $90, lends $810
Next borrower deposits $810. Bank keeps $81, lends $729
Process continues...
Total Money Created (First 4 Rounds):
Note: This is a simplified example. In reality, people also hold cash, and not all loans are redeposited. The actual money multiplier is usually lower than the theoretical maximum.
Key Concepts
Fractional Reserve Banking
Banks only keep a fraction of deposits as reserves. The rest can be lent out.
Reserve Requirements
The percentage of deposits banks must keep in reserve (set by central banks).
Money Multiplier Effect
When banks lend money, it gets deposited again, creating more money in the economy.
How Banks Make Money
Banks earn interest on loans while paying lower interest on deposits.
What Happens to Your Money
When you deposit money, it becomes a liability for the bank (they owe it to you).
Risks of Fractional Reserves
If too many people withdraw at once (bank run), banks might not have enough reserves.
How Banks Make Money
Interest Rate Spread
Example: Bank pays 1% on $1,000 deposit = $10/year. Bank lends $900 at 6% = $54/year. Profit: $54 - $10 = $44/year from your $1,000 deposit!
Reserve Requirements Around the World
United States
Large Banks: 10% (on deposits over $127.5M)
Small Banks: 0% (no reserve requirement since 2020)
European Union
Standard: 1% (minimum reserve requirement)
Set by European Central Bank
China
Large Banks: 13%
Small Banks: 8%
Brazil
Standard: 21%
One of the highest in the world
Risks and Protections
⚠️ Bank Runs
If too many depositors try to withdraw at once, banks might not have enough reserves. This is called a bank run.
Protection: FDIC insurance (US) protects deposits up to $250,000 per account. Central banks can also act as "lender of last resort" to provide emergency funds.
🛡️ Government Protections
- FDIC Insurance (US): Up to $250,000 per depositor, per bank
- Central Bank Support: Can provide emergency loans to banks
- Regulation: Banks must meet capital requirements and undergo regular audits
- Reserve Requirements: Minimum reserves help ensure banks can handle withdrawals
Key Takeaways
💰 Banks Don't Keep All Your Money
Banks only keep a fraction (reserve) of deposits. The rest is lent out to make profit.
📈 Money Multiplier Effect
When banks lend, money gets redeposited, creating more money in the economy than the original deposit.
💵 Your Deposit is an IOU
When you deposit money, the bank owes it to you. It's not physical cash sitting in a vault.
🏦 Banks Make Money on Spread
Banks profit from the difference between interest paid on deposits and interest charged on loans.
🛡️ Government Insurance Protects You
FDIC insurance (US) protects deposits up to $250,000, reducing the risk of losing your money.
⚖️ Balance of Risk and Profit
Banks must balance lending (profit) with keeping reserves (safety) to handle withdrawals.