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How Fractional Reserve Banking Works and How Banks Create Money With It

The banking system, with all of its checks and balances, is confusing to many, including yours truly, but the idea of depositing our money in our accounts and then banks use that money to lend to others is central to the banking system. The fractional reserve system allows banks to use our deposits to grow their revenues and stoke the fire of the economy.

Deposits help a bank grow its revenues because those loans generate interest income from the loan balances. As banks grow their deposits, it grows their ability to lend out more money.

When monetary policies are freer, such as more liberal lending policies, banks can lend out more money to help stimulate growth in the economy. That money companies use to buy inventory, build new restaurants, buy equipment, invest in new systems and people. All of which drives more growth for the economy.

In today’s post, we will learn:

  • What is Fractional Reserve Banking?
  • How Does Fractional Reserve Banking Work?
  • How Banks Create Money In A Fractional Reserve Banking?
  • What is Wrong With Fractional Reserve Banking?
  • Investor Takeaway

Okay, let’s dive in and learn more about fractional reserve banking.

What is Fractional Reserve Banking?

Fractional reserve banking, according to Investopedia:

Fractional reserve banking is a system in which only a fraction of bank deposits are backed by actual cash on hand and available for withdrawal.”

The theory behind this idea is that it can expand the economy by freeing up capital for lending, giving more growth opportunities. The banks do this by using customer deposits to make new loans and reward them by giving them interest on their deposits.

Those deposits are held as reserves in the bank’s account with the central bank or currency in their bank. For example, Wells Fargo takes part of your deposit and adds it to their account with the central bank as a reserve.

The reserve requirement allows commercial banks to act as go-betweens between the savers and borrowers by providing loans for borrowers and creating liquidity for depositors who wish to withdraw their money.

A brief flash of history, where did this system start?

Most historians think that the idea of fractional reserve banking began with ancient goldsmiths. These goldsmiths stored precious metals in their vaults, and people trusted them enough to deposit their precious metals in the goldsmith’s vaults. Over time, the goldsmiths realized they could lend out this gold to earn investment and then return the gold to the vault before someone would want to withdraw the gold.

One flaw in the system, if creditors (depositors of the original gold) lost faith in the goldsmith’s ability to pay back the gold, many deposits would want to redeem their gold at the same time. If the goldsmith had no way to raise enough gold, then it would default on its loans. The above situation is known as a bank run and was the ruin of many banks during the Great Depression.

To avoid these types of bank runs, central banks were born in 1668 in Sweden. These early central banks were given the authority to set reserve requirements and set the monetary base (assets) to hold the central bank’s reserves. To help lessen the impacts of bank runs, the central banks held the authority to assist in bank-to-bank transfers and act as lenders of last resort if any bank faced a bank run.

When we deposit at a bank, the funds are no longer our property. Instead, the funds become the property of Wells Fargo, and we receive an asset in the form of a checking or savings account. That deposit is a liability on the bank’s balance sheet because, at some point, the depositor will want their money back.

In the U.S., the fractional reserve banking system arose as a solution to the problems stemming from the bank runs during the Great Depression, with depositors demanding their deposits, putting great strain on the banks.

The government introduced the idea of reserve requirements to help protect depositor’s funds from investments in risky ventures.

How Does Fractional Reserve Banking Work?

As we discussed above, the reserve requirements of a bank require them to hold a portion of deposits back as a form of liquidity for the bank and insurance policy for depositors.

For example, if we deposit $1,000 at our local Wells Fargo branch, the bank can’t lend out the whole $1,000. It doesn’t have to keep all $1,000 in its vaults; instead, the bank is required to keep 10% of the deposit on hand, or $100 as a reserve. That allows the bank to lend out the extra $900.

The Federal Reserve sets the requirements for reserves as part of its toolbox to control monetary policy; if the Fed increases the reserve requirements, that action takes money out of the system, while lowering reserves puts more money into the system.

In the most recent depression, March 2020, the Fed set higher reserve levels for banks in the form of loan loss reserves because there was a lot of fear about loan defaults, and to get ahead of the anticipated defaults, the Fed required banks to hold bank larger portions of their earnings as reserves.

Depository institutions (banks) must report all activity to the Fed, items such as:

  • Transaction accounts
  • CD and savings accounts
  • Vault cash
  • Other reserves

The above items are reported either weekly or monthly, and some banks are exempt from the reserve requirements, but all banks receive interest on their reserves, referred to as “interest rate on reserves.”

Banks with less than $16.3 million in assets do not have to hold reserves, while banks with more than $16.3 million but less than $124.2 million needed to hold 3% as a reserve. Any bank holding more than $124.2 million needs to hold 10% as a reserve, including all major banks such as JP Morgan, Citibank, Bank of America, and Wells Fargo.

Let’s explore the reserve system for a moment.

Central Bank reserves are deposits on reserve with the Central Bank, with these reserves issued by the Federal Reserve. This might sound not very clear because none of us ever deposit any money with the Central Bank.

The reserve system is a payment system for banks, which means we can think of the banking system as two-tiered. The deposit system we all use for everyday banking and the reserve system that all banks use with accounts with the Federal Reserve.

Before creating the Federal Reserve, the banking system was entirely dependent on the strength of private banks, but when there were tough times, the economy would slide into recession. During 1907 there was an especially bad situation that required J.P. Morgan to bail out the banking system, which led to the Federal Reserve forming in 1913.

The decentralized banking system created with the Fed allows the Fed to oversee the banking system and manage payments between banks.

For example, if Wells Fargo loans us $100 and the Central Bank requires a 10% reserve, the Central Bank will create a $10 deposit for Wells Fargo. That reserve deposit is an asset for Wells Fargo, but it is also a liability because it owes the Central Bank $10. For the Central Bank, the $10 reserve is a deposit liability and a $10 loan asset.

How Banks Create Money In A Fractional Reserve Banking

The term “fractional reserve” relates to the fraction of deposits held in reserves. For example, if Wells Fargo holds $500 million in assets, it must hold $50 million in reserves or 10% of its deposits.

So, if Wells Fargo has $450 million in can loan out, it accepts promissory notes in exchange for the credit given to the borrower, which then deposits the cash in the borrower’s account. That is all part of the process of “creating” money in the banking system.

When Wells Fargo issues a loan for $1,000, that creates new money, which in turn increases the money supply; for example, let’s say we borrow $100,000 for a mortgage, Wells Fargo will credit our account with money equal to the size of the mortgage. Banks do this instead of giving us currency equal to the value of the loan.

Let’s talk a bit about money for a moment.

The primary role of “money” is to serve as an acceptable form of payment. Money can and has come in many forms, but in today’s modern banking system, payment comes from a deposit in our account. When we conduct a transaction via the fintech system, we transfer money electronically from our account to the merchant’s account through a payment system. No actual currency changes hands, but the electronic additions and subtractions from related accounts amount to what we all consider money.

Money was created to facilitate the ease of exchange of goods. Instead of trading a cow for a plow, we exchange “money” for that transaction.

In the U.S., the monetary system is controlled by private banks such as Wells Fargo, which help create loans that create deposits (money). And despite popular opinion, the Federal government doesn’t “create” money; instead, it comes from the process of deposits and loans.

The Federal Reserve’s role in creating money is regulation and managing the infrastructure that allows money to flow. The Federal Reserve controls “outside money,” which comes from reserves, cash notes, and coins, where the “inside money” comes from the creation of deposits and loans.

The best way to think of money is as a social contract. We all agree that the dollar is money and what a dollar is worth; it would lead to chaos if that breaks down. That applies to cryptocurrency too, if people accept it as a means of payment, it becomes money.

It is not necessarily a physical thing or carries an intrinsic value. Instead, it is a medium of exchange that both parties agree to use, allowing for a record of transactions.

That all leads us to the money multiplier.

The money multiplier measures how much money can be created using a specific unit of central bank money. Please think of the difference between the two tiers; commercial bank money is the demand deposits (savings, checking) in our bank that we use to write checks or pay bills with our debit cards. Central bank money is the money adopted by the central bank and includes reserves held in accounts with the central bank, precious metals, coins, and banknotes.

Analysts use the following formula to determine the multiplier equation and to estimate its effects on the economy. The formula is:

m = 1/R

Where:

m = the money multiplier

R = reserve requirement

Using the equation, we can see that the central bank can alter the money supply by altering the reserve requirement. For example, if it sets the reserve requirement at 10%, it creates a money supply equal to 10 times the amount of the reserves.

So, if Wells Fargo has $500 million in reserves, it can loan up to $5 billion. Or if they have a reserve of $10 million, they can loan $100 million.

Then banks create money from a combination of fractional reserves requirements and the money multiplier. If the reserves expand, it will allow more borrowing, where if it contracts, it pulls back on the borrowing. Again, there is no actual cash going into the system; rather, credits and debits are added to the corresponding accounts.

Examples of Fractional Reserves on a Bank Balance Sheet

Let’s take a look at the balance sheet of a couple of banks to understand how this works on their balance sheet. The bank’s balance sheet contains all the cash, cash reserves, and deposits for the banks.

For our first guinea pig, we will use Wells Fargo and their latest 10-q dated March 31, 2021.

To determine the cash reserve for Wells Fargo, we will use the total cash and divide that by the total deposits.

March 31

December 31

Total cash (A)

$286,733

$264,612

Total deposits (B)

$1,437,119

$1,404,381

Cash Reserve %

19.99%

18.84%


Pretty simple, huh?

Let’s look at one more, Ally Bank and their latest 10-q dated May 3, 2021.

Pulling the information from the above balance sheet:

March 31

December 31

Total cash

$15,578

$15,621

Total deposits

$139,585

$137,036

Cash Reserve %

11.16%

11.39%


What does all the above tell us? In the case of Wells Fargo, they are still in the penalty box with the Federal Reserve because of their past discretions. And because of those penalties, they carry higher cash balances and restrict the number of assets or loans the bank can carry.

Where Ally has a reserve level closer to the amounts required by the Federal Reserve, which allows Ally to lend out more money, but their loan balances are nowhere near the threshold with a total of $109 billion.

Doing the quick calculation is an easy way to see how the cash reserves impact the companies ability to raise more funds with deposits and loans.

Investor Takeaway

Understanding the fractional reserve system helps us understand the banking industry and its impact on the economy and how banks make money. Most banks make money from both the spread between the money they borrow and the money they lend out. Plus, they make money on fees for different services such as investment banking.

All the fractional reserve system tells us is how the reserve requirements manage the risk for banks, plus helping to create more liquidity in the economy. Encouraging more borrowing helps grease the wheels of the economy and is largely why the continuation of quantitative easing in today’s world.

But the fractional reserve banking system is not without its critics. Many believe it is immoral because it creates money out of thin air, and there is no actual money behind the transactions and leads to fraud in the financial system.

And the money multiplier comes under some fire, too, as it leads to expansion of the supply of money without much control. It also could encourage out-of-control inflation, which is the major worry for most investors.

The bottom line is the fractional reserve banking system has been in use for hundreds of years, and with the rise of cryptocurrencies, there is a lot of speculation about the changing winds of currencies and what comes next.

And with that, we will wrap up our discussion on fractional reserve banking.

As always, thank you for taking the time to read today’s post, and I hope you find something of value in your investing journey. If I can be of any further assistance, please don’t hesitate to reach out.

Until next time, take care and be safe out there,

Dave