How Fractional Reserve Banking Works
How Fractional Reserve Banking Works
By Raphael Zeder | Last updated Jun 26, 2020 (Published Jul 15, 2017)
Fractional reserve banking is a banking system in which banks only hold a fraction of the money their customers’ deposit as reserves. This allows them to use the rest of it to make loans and thereby essentially create new money. This gives commercial banks the power to directly affect the money supply.
In fact, even though central banks are in charge of controlling the money supply, most of the money in modern economies is created by commercial banks through fractional reserve banking. To understand how exactly this works, we will look at the process in more detail below.
100 Percent Reserve Banking
To explain the idea behind fractional reserve banking, we first have to consider its opposite: 100 percent reserve banking. In this system, banks are required to hold all deposits as reserves. To give an example, let’s assume we have an economy with a money supply of USD 100 million.
In this economy, the first-ever bank just opened, we’ll call it the Super Safe Bank. This bank is only a depository institution. That means, it accepts deposits, but it does not give out any loans. By keeping all deposits in its vault (i.e. as reserves) the bank provides its customers with a safe place to keep their money. Nothing more, and nothing less.
Depositors can return anytime and withdraw their deposit. Even if all of them do this at the same time, there is no shortage of cash, because all the money is stored in the bank’s vault. In other words, all the bank’s liabilities (i.e. deposits) are covered by the reserves (i.e. assets). We can illustrate this by creating a T-account for the Super Safe Bank.
Now, let’s look at the money supply in this example. Before Super Safe Bank opened, people had to hold all USD 100 million in cash. Now they can deposit all their money in the bank. Every deposit they make reduces the currency in circulation and increases demand deposits by the exact same amount.
As a consequence, money supply (which also includes demand deposits) remains unchanged. Thus, in the case of 100 percent reserve banking, banks cannot control or influence the money supply.
Fractional Reserve Banking
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