Fractional Reserve Banking
Your deposit isn't just sitting in a vault
When you deposit $1,000 in a bank, the bank doesn't lock it in a vault waiting for you to withdraw it. Under fractional reserve banking, it keeps only a fraction as reserves and lends the rest out, earning interest on those loans. Historically regulators set a specific minimum reserve ratio; in practice, modern frameworks (like the US's post-2020 approach) often rely more on capital and liquidity requirements than a single fixed reserve ratio, but the core mechanism — banks lending out most of what's deposited — is unchanged.
How this creates new money
That loaned-out money typically gets spent and re-deposited into the banking system, where the receiving bank again lends out most of it. Repeated across the whole system, this process effectively multiplies the original deposit into a much larger amount of total money in circulation — without printing a single new banknote.
- You deposit $1,000. The bank keeps a reserve and lends out the rest.
- The borrower spends it; the recipient deposits it in (possibly) another bank.
- That bank again keeps a reserve and lends out the rest — and the cycle repeats.
- The theoretical ceiling on total money created is roughly the original deposit divided by the reserve ratio.
Key Formula / Concept — Simple Money Multiplier
Max New Money ≈ Initial Deposit ÷ Reserve Ratio
At a 10% reserve ratio, a $1,000 deposit can theoretically support up to $10,000 of total deposits system-wide. Real-world figures are usually lower due to cash holdings, excess reserves, and loan demand.
Pro Tip
This is exactly why a "bank run" (everyone trying to withdraw at once) is dangerous: the bank genuinely does not hold everyone's full deposit in cash at the same time — it's largely out as loans.
Checkpoint Quiz
Checkpoint Quiz
Question 1 of 5Under fractional reserve banking, what does a bank do with most of a customer's deposit?