Fractional Reserve Banking
Understanding how banks create money through fractional reserve banking
What is Fractional Reserve Banking?
Simple Definition
Fractional Reserve Banking is a system where banks only keep a fraction (portion) of customer deposits as reserves. They lend out the rest, creating new money in the process.
Key Concept
If you deposit $1,000, the bank might keep $100 (10%) as reserves and lend out $900. That $900 gets deposited elsewhere, creating more money. This multiplies the money supply.
Why It Matters
Fractional reserve banking allows banks to create money through lending. This is how most money in the economy is created - not by printing, but by banks making loans.
How Fractional Reserve Banking Works
Customer Deposits Money
You deposit $1,000 into Bank A. The bank promises to return this money when you request it.
Bank Keeps Reserves
Bank A keeps a fraction as reserves (e.g., 10% = $100). This is required by law and ensures the bank can handle withdrawals.
Bank Lends the Rest
Bank A lends out the remaining $900 to a borrower. This creates new money - the borrower now has $900 that didn't exist before.
Money Gets Redeposited
The borrower spends the $900, and it gets deposited in Bank B. Bank B now has $900 in new deposits.
Process Repeats
Bank B keeps $90 (10%) and lends $810. This process continues, creating more and more money from the original $1,000 deposit.
Money Multiplier Effect
Your original $1,000 deposit can create $10,000+ in the economy through this process. This is the money multiplier effect.
Money Multiplier Calculator
Money Multiplier Effect
Step-by-Step Example
Bank A
Bank B
Bank C
Summary
From your initial $1,000 deposit with a 10% reserve ratio, the banking system can theoretically create up to $10,000.00. That's $9,000.00 in new money!
Reserve Requirements
What Are Reserve Requirements?
Reserve requirements are the minimum amount of deposits that banks must keep as reserves and cannot lend out. This is set by central banks (like the Federal Reserve in the US).
🇺🇸 United States
Current: 0% (as of 2020)
Historical: 3-10% typically
Note: Fed eliminated reserve requirements but banks still hold reserves for operational needs
🇪🇺 European Union
Current: 1%
Set by: European Central Bank
Applies to: All banks in the Eurozone
🇨🇳 China
Current: 7-12% (varies by bank size)
Set by: People's Bank of China
Purpose: Control money supply and inflation
The Money Multiplier Formula
Formula
Money Multiplier = 1 / Reserve Ratio
Total Money = Initial Deposit × Money Multiplier
Example 1: 10% Reserve Ratio
Multiplier = 1 / 0.10 = 10x
$1,000 deposit can create $10,000
Example 2: 20% Reserve Ratio
Multiplier = 1 / 0.20 = 5x
$1,000 deposit can create $5,000
Example 3: 5% Reserve Ratio
Multiplier = 1 / 0.05 = 20x
$1,000 deposit can create $20,000
Risks and Benefits
✅ Benefits
- Expands money supply to support economic growth
- Allows banks to earn profit from lending
- Provides credit to businesses and individuals
- Enables economic expansion
- More efficient use of money
- Supports investment and entrepreneurship
⚠️ Risks
- Bank runs (if too many people withdraw at once)
- Systemic risk (one bank failure can affect others)
- Inflation risk (too much money creation)
- Leverage risk (banks are highly leveraged)
- Moral hazard (banks take excessive risks)
- Financial instability
The Bank Run Problem
What is a Bank Run?
A bank run occurs when many depositors try to withdraw their money at the same time. Since banks only keep a fraction of deposits as reserves, they can't pay everyone at once.
Example of a Bank Run
Bank has $1,000,000 in deposits
Keeps $100,000 as reserves (10%)
Has lent out $900,000
Rumors spread that the bank is in trouble
Depositors panic and rush to withdraw
Bank only has $100,000 in reserves
Can't pay all $1,000,000 in deposits
Bank fails or needs government bailout
Protection Against Bank Runs
- FDIC Insurance: US government insures deposits up to $250,000
- Central Bank Lending: Banks can borrow from central bank in emergencies
- Reserve Requirements: Ensures banks keep some reserves
- Regulation: Government oversight and stress testing
Fractional Reserves vs Cryptocurrency
Traditional Banking (Fractional Reserves)
- Banks create money through lending
- Only keep fraction of deposits
- Money supply can expand/contract
- Central bank controls reserve requirements
- Risk of bank runs
- Money multiplier effect
- Inflationary (more money created)
Cryptocurrency (No Fractional Reserves)
- Fixed or algorithmic supply
- No lending creates new tokens
- Supply is predetermined
- No central authority controls supply
- No bank runs (no banks)
- No money multiplier
- Can be deflationary (fixed supply)
Key Takeaways
🏦 What It Is
Fractional reserve banking means banks only keep a fraction of deposits as reserves. They lend out the rest, creating new money in the process.
💰 Money Creation
Banks don't just store money - they create it. A $1,000 deposit can create $10,000+ in the economy through the money multiplier effect.
📊 The Multiplier
The money multiplier = 1 / reserve ratio. Lower reserve ratios = higher multipliers = more money created. A 10% reserve ratio creates a 10x multiplier.
⚠️ Bank Run Risk
Since banks only keep a fraction of deposits, they can't pay everyone at once. This creates the risk of bank runs if too many people withdraw simultaneously.
🛡️ Protection
FDIC insurance, central bank lending, and regulations protect against bank runs. However, the system is still vulnerable to systemic crises.
🪙 Crypto Alternative
Cryptocurrency doesn't use fractional reserves. Supply is fixed or algorithmic. No banks create money through lending. This eliminates bank run risk but also eliminates the money creation mechanism.