What is Fractional Reserve Banking? How Banks Create Money

Fractional reserve banking is a system where banks use lending to multiply money. It’s similar to creating money out of thin air. So, if you store your savings at a bank or invest in the markets, this concept is useful to know. Our modern banking system relies on it. 

To start out, I’ll explain some quick banking basics and then how fractional reserve banking works, along with an example. After that, I’ll show you some important historical events that have led to the current system.

Many people find these topics dry… but they’re anything but that. You’re about to see what I mean. And by the end, you’ll have a better understanding of our economy. 

Fractional Banking Explained with an Example 

Banks provide a useful service. They keep our money safe and even pay us a little interest. But how do they make money? It doesn’t cost us anything to open a savings or checking account. 

One way that banks make money is by lending. With our savings on their books, they can turn around and give out loans. Those loans have higher interest rates. So, banks make money on our savings – after their operational costs. 

Here’s the problem though. If a bank takes your money and lends it to someone else, what happens if you want it all back at once? To prevent this liquidity problem, there are many banking rules in place. And one important rule is the reserve requirement

Required Reserve Ratio: The percentage of total savings that a bank must legally hold in reserve.

Formula: Required Reserves = Reserve Ratio × Deposits 

In the U.S. the reserve requirement for big banks was set at 10%. But recently, the Fed has knocked it down to a dangerous 0%. I’ll discuss that below, but first let’s use 10% to see how fractional reserve banking works. 

Alright, let’s say you set up a new account at a bank. You put in $100,000 and then the bank has to keep 10% or $10,000 in reserve. So, the remaining $90,000 the bank lends out to make money. 

Now, let’s say a business takes out that $90,000 loan and doesn’t plan on spending it right away. So, to keep it safe, the business deposits it right back into the bank. The bank now has customer deposits of $190,000 on its books. 

The bank can then take the new $90,000 deposit and lend out 90% of that, which is $81,000. That new $81,000 loan to someone else then shifts back into the bank. And total customer deposits from these transactions now reach $271,000 ($100,000 + $90,000 + $81,000). 

This trend continues and I’ve charted how that original real $100,000 grows… 

How fractional reserve banking works with a 10% reserve requirement ratio

This is one way that money in our economic system multiplies. And the reserve requirement is vital to banks’ liquidity and loaning potential in the market. I’ve also charted the potential growth of an initial deposit with different reserve ratios for comparison. 

Creating money with fractional banking and different reserve ratios in our modern monetary world

It has a big, compounding impact on bank safety and market activity. So, it makes sense that governments want to control the reserve ratio. Although, the recent drop to 0% to promote lending is risky. And it would have been even more dangerous in the past… 

History of Bank Runs and Modern Monetary Control 

During the Great Depression, which started in 1929, the stock market tanked and unemployment soared. In the beginning, only a few banks failed. As a result, families who had deposits at those banks lost their savings. But as word spread, more people started running to their banks to take money out. 

Now, with your new understanding of the fractional reserve system, you know that banks didn’t have enough money on hand. Banks couldn’t meet the withdrawal demands and were forced to call back loans. The economy and banking system collapsed. By the end, about 7,000 banks had failed

To prevent future bank runs, the government stepped in with new monetary controls. And enforcing better reserve requirements was just one of many actions. In 1933, the FDIC popped up to insure bank deposits up to a certain level. And today, each depositor is insured to at least $250,000 per insured bank. This has helped build trust and prevent bank runs. 

On top of that, there’s also been a seismic shift with our monetary system. Up until 1971, you could convert your dollars into gold. But that changed since the U.S. didn’t have adequate gold reserves to keep its promise. 

Side Note: I invested in gold in my early days before learning more about investing. Over the years – and thousands of hours of research – I’ve learned that Gold is a Bad Investment. Check out that link to see the six reasons why I avoid investing in precious metals. 

Back to the current monetary system, your U.S. dollars are now fiat. A fiat currency has nothing but the government behind it. It’s a system built on trust. And the government has taken other big steps to control your money. For example, banks are now required to report any withdrawals above $10,000. 

The government has thousands of new rules in place. But these rules show a lack of trust in citizens. It’s ironic. Many of the rules have good intentions, like preventing money laundering, but come at a heavy cost. Giving away some freedoms often leads to the loss of more freedom. I digress… 

The monetary system has become safer in many ways. Fractional reserve banking is a far cry from its early, less regulated days. Although, there are tradeoffs. In the coming months, I’ll give you more insight. So, stay tuned and please reach out with any comments or questions. 

Invest mindfully, 

Brian Kehm 

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