How Fractional Reserve Banking Works

Article and Review by GlobalMacroForex

Fractional Reserve Banking is a system that most modern economies (including America) use.  It starts when someone deposits $100 in a bank as a demand deposit,

Next, the bank makes a loan.  Now banks are required to keep 10% of their demand deposit liabilities in cash with the Federal Reserve.

So with this $100 liability, they can only loan out $90,

This second individual deposits his (or her) loan money in a different bank, and the second bank makes a loan.  Since again they need to keep 10% as reserves, bank 2’s loan is $81 to a third customer,

This new third customer that got the money, deposits it back in bank 1.  Even though bank 1 “created this money” out of nothing, they again get a new liability/assets.  So they can re-loan it out just as if it were new money created by the Fed,

This continues until the money supply is drastically increased by 10 fold.  Consider this table on the left with the loan amounts in the left column and the total money supply on the right column.

Now, this process does have an end at about 10x the money supply, but that’s assuming that the new bank depositors put their money in demand deposits.  What if they go with time deposits?  Then the money supply growth gets cut off and a single few demand deposits are leveraging a huge amount of time deposits.  This  money supply growth is what drives up asset prices.  Without it, asset prices would crash.

If we compare the total amount of US Commercial Bank loans to the Fed’s numbers on Demand Deposits, we can see clearly, when the assets are peaking in demand deposits (women to birth more).

When I wrote an article on Murry Rothbard’s bookAmerica’s Great Depression, we found the same pattern; the 1920s economy had a higher proportion of time deposits to demand deposits.  This made the bank deposits more leveraged.

In 1929, just like 2007, both bubbles were the overleveraging time deposits on small amounts of demand deposits.  This is also why the yield curve flattens and inverts before the bubble bursts.  It’s people investing in time deposits, driving down long-term rates, while demand deposits (the start of the yield curve) has it’s rate peak because there aren’t enough demand deposits to go around.

So not just large banks, but all fractional reserve banks are “too big to fail” because their personal profit directly influences how much money exists in the economy.  The Federal Reserve creates more demand deposits in a crisis, which allows banks to enjoy private profits in good times, but socialized failure in bad times. 

In my next article, I will explain how fractional reserve banking works on an international level.  You will learn why foreigners cannot really cash out.  Eurodollars are NOT Federal Reserve notes nor are they Petrodollars.  It is an entirely different system; please see How the Eurodollar system really works.