Understanding the Fractional Reserve Banking System | Investing Basics

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Understanding the Fractional Reserve Banking System

How Banks Turn a Little Bit of Money Into a Lot of Money

When you put your money into a savings account or a checking account at a bank, the bank doesn't just sock it away in a vault underground somewhere. Instead, it lends your money to other individuals and companies who need it.

As you will see in the video, thanks to the magic of fractional banking, when your banks lends your money to other people, it is actually creating money.

Fractional Reserve Banking

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.

To learn more about what objectives the fractional reserve banking system helps the Federal Reserve achieve, check out The Goals of the Federal Reserve.

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)

Understanding Fractional Reserve Banking: Video Lesson

I've scratched the surface of this topic in the article above, but I go into more detail about how the fractional-reserve banking system works and the effect it has on the economy during both good and bad times in the Understanding the Fractional Reserve Banking System. Click here to watch.