Fractional Reserve Banking

How Banks Create Money

Life is Good for Bankers

Inflation and Stability

How Banks Create Money

Fractional reserve banking is the engine of capitalism. It enables banks to create money out of thin air. Technically, the new money is a ledger record on a server.

For example, let us 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 that $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 who deposits the $900 in Bank B. Bank B holds $90 in reserve and lends $810 to Tommy to buy a pair of skis. The ski shop deposits $810 in Bank C. Bank C holds $81 in reserves and lends $729 to Carol to keep the process rolling.

Bank A’s loan to John, Bank B’s loan to Tommy, and Bank C’s loan to Carol increased the money supply by $2,439 ($900 + $810 + 729). 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 the $900 to Mary’s Bank B account to pay for John’s scooter.

As John repays the loan, the $900 leaves the money supply. The money Bank A created by lending $900 to John no longer exists. Each of John's loan payments includes principal and interest. Bank A can use that money to increase reserves and make new loans. The cycle continues.

Life is Good for 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 by posting ledger entries.

The loan customers who borrow the $9,000 all owe principal plus interest to their banks.

Life is Better for 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.

All but the largest 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 high-risk borrowers 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.

Large Bank Capital Requirements

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

In August 2025, the Fed published the large bank capital requirements for 31 banks.^[2] The requirements ranged from 7.0% to 11.8%, except DB USA Corporation is required to hold 16.0% in reserves.

The FED does not use the phrase "too big to fail" to discribe these banks, but it is implied. All of them are larger than First Republic or Silicon Valley. The failures of First Republic and Silicon Valley were large enough to make markets nervous.

Benefits for Society

Before fractional reserve banking, only the lords of the manor, the wealthiest merchants, and the church had access to capital. Fractional reserve banking made financial capital abundant and cheap.

Farmers, craftsmen, and merchants of modest means were able to access capital. The rise of the middle class sustained the Renaissance and the Industrial Revolution.

Banks can create all the capital we need can from middle-class savings, unless the wealthy have all the money. There is no need for public policies that favor the rich.

Labor and capital and combine to create goods and services. They also produce assets like tools, machines, buildings and intellectual property which are forms of capital. The broad definition of capital includes any asset that can be used to produce goods and services or other forms of capital.

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. For these reasons, we must vigilantly regulate banks.

The goals are economic growth, more good jobs, and higher living standards. To achieve these goals, we need low interest rates and low inflation. To achieve both we need to avoid situations that require interest rate increases to slow inflation. Difficult business indeed.

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

Competition is Key

Capitalism is powerful because it allows competitive markets and drives capital formation with fractional reserve banking.

Perfect markets do not exist, but vigorous antitrust enforcement and rules that encourage productive investment can sustain markets that are efficient and fair. Monopolies and oligopolies are the enemy of efficiency and fairness.

Congress controls the budget and makes the rules with the approval of the president (or an override of a presidential veto). The president appoints the Federal Reserve board with the approval of the senate.

Economic policy should guide the economy to do what needs to be done. This is not easy; democracy requires informed voters and fair elections. To control our economic fate, we must elect responsible leaders who work for the American people, not the billionaires and the donor class.