Fractional Reserve Banking

How Banks Create Money

Fractional reserve banking is the engine of capitalism. It enables banks to create money out of thin air. Technically, the money is a series of ones and zeros on a server.

For example, let’s assume the banks have a 10% reserve requirement. If you deposit $1000 in Bank A, they must hold $100 in reserve, they can lend the remaining $900.

John borrows the $900 from Bank A. You still have $1,000 on deposit and John owes Bank A $900. Bank A created $900 by loaning $900 to John.

John buys a $900 scooter from Mary. Mary deposits the $900 in Bank B. Bank B holds $90 in reserve and lends $810 to Tommy. Tommy will spend the $810 to keep the process rolling.

Bank A’s loan to John, and Bank B’s loan to Tommy increased the money supply by $1,710 ($900 + $810). As the process continues the money supply can grow as much as $9,000.

Bank A did not give John $900 in cash, they put $900 in John’s account. Or they might have transferred $900 to Mary’s Bank B account to pay for John’s scooter. Either way, it is just a series of ones and zeros on a server.

As John repays the loan, the $900 leaves the money supply. The money Bank A created by lending $900 to John no longer exists. John's repayment allows Bank A to increase reserves and make new loans. The cycle continues.

From the Bankers Point of View

Life is good for the bankers. If you deposit $1,000, a bank can add the $1,000 to its reserves and lend up to $9,000. Money the bank creates from thin air.

The money can move quickly. The $900 loaned to John went to Mary in exchange for the scooter. Mary’s Bank B lent Tommy $810. The loan customers who borrow the $9,000 all owe principle plus interest to their banks.

A bank only needs to hold $1000 in reserves to create $9,000. Traditionally, banks do not earn interest on their reserves. They earn interest from the loans.

But now life is even better for the bankers. On March 26, 2020, the Federal Reserve (Fed) lowered the reserve requirement to 0%^[1]. To encourage banks to hold reserves, the Fed now pays interest on reserve deposits.

Most US banks have no set limits on the amount of money they can create. However, banks may be cautious, or they may struggle to find enough worthy loan customers.

Banks can fail when they loan too much to unworthy customers or make other bad investments. Fifteen bank failures occurred from 10/25/2019 to 01/17/2025. Two of these, First Republic Bank and Silicon Valley Bank, were among the largest bank failures in American history.

When the economy slows, reluctant banks often lend less money. When the economy is growing, banks are more willing to lend. Unfortunately, we need the banks to make more loans in a slow economy and fewer loans when the economy runs hot.

Large Bank Capital Requirements

Each year, the Fed conducts stress tests of the largest banks. The Fed sets reserve requirements for large banks based on the stress test results.

In August 2024 the Fed published the large bank capital requirements to be effective on October 1, 2024.^[2] The Fed did not use the phrase “too big to fail” to describe the 32 banks listed. These banks are larger than First Republic or Silicon Valley and the failures of First Republic and Silicon Valley were large enough to make markets nervous.

The requirements ranged from 7.0% to 13.8%, except DB USA Corporation was required to hold 18.4% in reserves.

Inflation and Stability

We have a debt based monetary system. New money is created by loans. The new money is eliminated as the loans are paid off. This should avoid inflation, but banks continuously make new loans. Over time, the money supply grows.

Inflation occurs when the money supply grows faster than our economic output. Worse, bank failures can disrupt the economy. We must vigilantly regulate banks for these reasons.

Capitalism is far from perfect, but it is the system we have and will have for the foreseeable future. There are alternatives, but none that I know are better. We need to make modern capitalism work for us.