Fractional Reserve Banking

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

In reality, most of it isn't in the vault at all. But not for the reason you were probably taught.

The textbook version goes like this: the bank keeps a fraction — say 10% — and lends the other $900 out. That $900 gets deposited at another bank, which lends out $810, and on and on, until your single $1,000 supposedly supports $9,000 of loans across the system. It even has a name — the money multiplier — and it's a tidy, memorable story.

It's also, as the Bank of England spelled out in 2014, not how banking actually works.

As you saw on Day 11, banks don't lend out the specific dollars you deposit. When a bank makes a loan, it creates a brand-new deposit — new money — on the spot. Your $1,000 isn't a seed that gets multiplied; each new loan mints its own new money. What really limits how much banks can create isn't a shrinking pile of reserves passed down a chain — it's regulation, capital requirements, the demand for loans, and whether borrowers can pay them back.

So why does any of this matter to you? Because of what it says about the money in your account. The dollars you "have" at the bank aren't stacked in a drawer with your name on them. They're a promise — a liability the bank owes you — while the cash itself has long since been put to work. The bank is betting that not everyone will ask for it back at once.

Usually, that bet is fine. Occasionally it isn't, and everyone tries to withdraw at the same time. That's a bank run. It has happened throughout history, and it happened in 2008 — when ordinary depositors discovered, too late, that the vault was never as full as they'd imagined.

For most people, most of the time, this all works. But it's worth knowing the difference between money you hold and money someone else is holding — and creating — on your behalf.

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

— The Daily Bit