In our modern banking system, banks are only required to keep a small fraction of their deposits on reserve in case depositors wish to withdraw their deposits. But why? Why shouldn’t banks keep all of our money?
The Federal Reserve explains it this way:
The fact that banks are required to keep on hand only a fraction of the funds deposited with them is a function of the banking business. Banks borrow funds from their depositors (those with savings) and in turn lend those funds to the banks’ borrowers (those in need of funds). Banks make money by charging borrowers more for a loan (a higher percentage interest rate) than is paid to depositors for use of their money. If banks did not lend out their available funds after meeting their reserve requirements, depositors might have to pay banks to provide safekeeping services for their money. For the economy and the banking system as a whole, the practice of keeping only a fraction of deposits on hand has an important cumulative effect. Referred to as the fractional reserve system, it permits the banking system to “create” money.
How Fractional Reserve Banking Works
When you put your money into a bank, the bank is required to keep a certain percentage, a fraction, of that money on reserve at the bank, but the bank can lend the rest out. For instance, if you deposit $100,000 at the bank and the bank has a reserve requirement of 10 percent, the bank must keep $10,000 of your money on reserve and can lend out the $90,000.
In essence, the bank has taken $100,000 and has turned it into $190,000 by giving you a $100,000 credit on your deposits and then lending the additional $90,000 out to someone else.
Now, if you take this out a little further, you will see that your original $100,000 can become $ by the time it is all over. Here’s how:
|– You deposit||$100,000||Your bank loans someone else||$90,000|
|– That person deposits||$90,000||Their bank loans someone else||$81,000|
|– That person deposits||$81,000||Their bank loans someone else||$72,900|
|– That person deposits||$72,900||Their bank loans someone else||$65,610|
|– That person deposits||$65,610||Their bank loans someone else||$59,049|
|– That person deposits||$59,049||Their bank loans someone else||$53,144|
|– That person deposits||$53,144||Their bank loans someone else||$47,829|
|– And so on|
Ultimately, your initial $100,000 can grow into $1,000,000 with a 10 percent reserve requirement.
To find out exactly how much money the fractional reserve banking system can theoretically create with your initial deposit, you can use the Money Multiplier equation:
– Total Money Created = Initial Deposit x (1 / Reserve Requirement)
For example, with the numbers we have used above, you equation would look like this:
– $1,000,000 = $100,000 x (1 / 0.10)