5.7: Fractional-Reserve Banking I

Fractional-reserve banking is a system in which banks hold only a portion of the deposits they receive as reserves, while the rest is made available for lending. To understand how this works, imagine a hypothetical economy. Assume that the entire money supply is deposited in banks for safekeeping. Each bank keeps aside a share of deposits as reserves and lends out the remaining amount.

In a bank's balance sheet, money deposited is recorded as a liability because the bank owes it to the depositor. On the assets side, reserves and loans are recorded. When a bank lends part of the deposits, it still owes the full amount to the depositors. This is because any of the depositors can withdraw all of their deposits at any time.

Banks lend money to borrowers. Once a loan is obtained, as the borrower prepares to use the loan to make a future purchase, they deposit it into another Bank for safekeeping. Each new deposit is recorded as a liability for the receiving bank. A portion is kept as reserves, and the rest is lent out again. In this way, deposits multiply across the banking system.

This system, in which banks keep only some of their deposits on reserve, is called fractional-reserve banking.

Imagine an economy where the central bank has created $100 in currency, which we call the monetary base. Let's see how it can lead to a larger total money supply. The public is assumed to deposit all the currency in banks.

Assume that each bank holds ten percent of its deposits as reserves and lends the rest. The reserve–deposit ratio is 10%.

The public deposits $100 in Bank A. The bank keeps $10 as reserves and lends out $90 of new loans. Bank A has $100 in deposits as liabilities, and its assets include $10 in reserves and a $90 loan. Though $90 is lent out, the full $100 deposit remains on the bank’s books as a liability.

The recipient of that $90 bank loan does not hold onto the currency. As they prepare to use the loan to make a future purchase, they deposit it into Bank B. So, the total money supply is $190: $100 in deposits in Bank A and $90 in deposits in Bank B.

This system, in which banks keep only some of their deposits on reserve, is called fractional-reserve banking.