Fractional Reserve Banking: How Banks Create Money (Legally)

Most people think banks take deposits and lend them out.

That’s partly true — but not the whole story.

Modern banking relies on fractional reserve banking, a system that underpins the entire financial system.

Once you understand it, a lot of economics suddenly makes sense.

The Basic Idea:

Under fractional reserve banking, banks do not keep all your money in a vault.

Instead:

• They keep a fraction of deposits as reserves

• They lend out the rest

  
  

As long as not everyone requests their money back at once, the system functions smoothly.

A Simple Example:

Imagine you deposit £1,000 into a bank.

If the required reserve ratio is 10%, the bank:

• Keeps £100 as reserves

• Lends out £900

  
  

That £900 doesn’t disappear. It is spent and then deposited into another bank.

That second bank:

• Keeps £90

• Lends out £810

  
  

This process repeats — and suddenly:

• The original £1,000 supports much more than £1,000 of money in the economy

This is known as money creation.

Where Does the New Money Come From?

Here’s the key insight:

Most money in the economy is created when banks make loans.

When a bank issues a loan, it doesn’t hand over existing cash — it creates a new deposit in your account.

That deposit is new money.

Central banks, like the Bank of England, control this process indirectly by:

• Setting interest rates

• Regulating banks

• Providing reserves when needed

  
  

But commercial banks do the day-to-day money creation.

Why Use This System?

Fractional reserve banking exists because it:

• Encourages lending and investment

• Supports economic growth

• Makes credit widely available

  
  

If banks were required to hold 100% of deposits in reserve, loans would be scarce, expensive, and economic growth would slow dramatically.

What Are the Risks?

The system relies on confidence.

Problems arise when:

• Too many people try to withdraw money at once

• Banks make risky loans

• Credit expands too quickly

This is why we have:

• Deposit insurance

• Central bank “lenders of last resort”

• Financial regulation

  
  

Without these, bank runs would be far more common.

Why Should You Care?

Fractional reserve banking explains:

• Why credit cycles happen

• How interest rate changes affect the economy

• Why banking crises can spread so fast

  
  

It also shows that money isn’t just printed — it’s created through lending decisions.

The Big Picture:

Fractional reserve banking isn’t a trick or a scam.

It’s a trade-off:

• More growth and credit

• In exchange for financial fragility

  
  

When managed well, it supports modern economies. When mismanaged, it can amplify booms and crashes.

Understanding it is a huge step toward understanding how the financial system really works.