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How Fractional-Reserve Banking Really Works

Fractional-reserve banking is a term that many of us have heard throughout the years, but what does it really mean? It can sound impressive and sound complicated, but how many of us have really taken the time to look behind the veil and learn just how this system really operates?

With this in mind, banks are required to keep reserves on hand equal to a percentage of their total deposit liabilities. That required reserve ratio can fluctuate, but often times 10% is given as the typical percentage for this requirement. So let’s say that you’re rummaging through the attic and you find an old trunk that grandpa used to have, and while going through the trunk, you find $1,000.00 cash. Then you take that money down to your bank and you deposit it. So both the bank and the overall banking system now have an additional $1,000.00 in deposits that previously did not exist, and the bank can now make some additional loans from these deposits.

Let’s say once again that the required reserve ratio is 10%, meaning that the bank must keep $100.00 in reserve out of the $1,000.00 in new deposits and that it can loan out the other $900.00. So this is where it can all begin to get interesting. Let’s say that the bank loans out the additional $900.00 to a borrower, and the borrower then begins paying interest on the loan. But now look at what just happened…the bank still has the $1,000.00 that was just deposited into it, and it has now made a $900.00 loan to someone, as an electronic deposit into their checking account, meaning that there’s now a total of $1,900.00 in new money in the banking system that came from the original $1,000.00 deposit!

So where did this additional $900.00 come from? It snapped into existence at the moment that the $900.00 loan was given to the borrower!

But with fractional-reserve banking, it now gets even more interesting. Let’s say, for example, that the person who borrowed the $900.00 from the bank now buys something for $900.00, and then that $900.00 is then deposited into the store’s bank. So the store’s bank now has an additional $900.00 in new deposits, and they can now loan out $810.00 (90%) of that money, while keeping $90.00, or 10% of the $900.00, as the required reserve.

This then continues building throughout the entire banking system, as more deposits are then made from these additional loans and the purchases that come from them until ultimately the banking system can then create approximately $9,000.00 in new loans from that initial $1,000.00 deposit!

While this seems incredible, for banks that are members of The Federal Reserve System, this is how the banking system operates. While there have been many books and articles written on this, if you’re interested in more information, the one book that’s considered to be the most thorough and detailed one ever written on the subject is “The Creature from Jekyll Island”, which was written by G. Edward Griffin.