Fractional Reserve Banking

Deposit $1,000 at your bank. In your mind, that money is sitting there — safe, waiting for you.

In reality, the bank is lending most of it out before you’ve left the building.

Under fractional reserve banking, banks are required to keep only a fraction of deposits on hand — historically around 10%, though in many countries today the requirement is even lower. The rest can be lent out.

So your $1,000 deposit allows the bank to lend $900 to someone else. That person deposits their loan in another bank. That bank lends out $810. And so on. Through this chain, your original $1,000 deposit can support up to $9,000 in new loans across the banking system.

This is called the money multiplier. One real dollar becomes many.

The system works as long as everyone doesn’t ask for their money back at the same time. When they do — that’s called a bank run. It’s happened throughout history. It happened in 2008. It’s always the ordinary depositors who find out, too late, that the vault was never as full as they imagined.

The uncomfortable truth: the money you believe you have in the bank is largely a legal promise, not a physical reality. The bank owes you that money. But they’ve already lent it to someone else.

For most people, most of the time, this works fine. But it’s worth understanding the difference between money you hold and money someone else is holding on your behalf.

Tomorrow: what happens when this system breaks down completely — a true story from 1920s Germany.

— The Daily Bit