Fractional Reserve Banking

How does fractional reserve banking create new money?

Contrary to the belief that banks lend out pre-existing deposits, modern fractional reserve banking creates money through the act of lending. When a bank approves a loan (e.g., $100,000), it simultaneously creates two entries on its balance sheet: an asset (the loan receivable) and a liability (a new deposit credited to the borrower's account). This new deposit constitutes new money that did not exist before the loan was approved. When the loan is repaid, the money is destroyed. This mechanism, confirmed by central banks like the Bank of England, means that the money supply is largely determined by commercial bank lending decisions, constrained primarily by capital adequacy ratios rather than mandatory reserve requirements.

What is the current status of mandatory reserve requirements in major economies?

A critical insight into modern banking is that most major developed economies have eliminated mandatory reserve requirements. The US Federal Reserve reduced its requirements to 0% in March 2020. Similarly, countries like the UK, Canada, Australia, and New Zealand operate without mandatory reserve ratios. Banks are no longer constrained by holding a fraction of deposits as reserves. Instead, their lending capacity is governed by international regulatory standards, specifically the Basel III framework, which imposes strict capital adequacy ratios to ensure banks can absorb unexpected losses.

If banks don't hold reserves, what prevents unlimited lending?

Unlimited lending is prevented by several factors, mainly capital requirements and liquidity management. Capital adequacy ratios (under Basel III) require banks to hold a certain amount of high-quality capital relative to their risk-weighted assets. This acts as the primary constraint on balance sheet expansion. Additionally, banks must manage liquidity risk—ensuring they have sufficient reserves to meet daily payment obligations (clearing) and customer withdrawals. While reserves are not required against deposits, they are essential for settling interbank payments through RTGS systems like Fedwire.

How does this system relate to the digital nature of money?

The fractional reserve system explains why 97% of money exists only as digital ledger entries. Your bank account balance is not cash stored in a vault; it is a liability—a promise the bank owes you. When you make a transfer, two ledgers are updated: your account is debited, and the recipient's account is credited. The final settlement between banks involves adjusting reserve balances at the central bank. This architecture, where money is created as debt and exists as database entries, is the fundamental reason why innovations like blockchain and stablecoins seek to introduce a single, shared ledger for faster settlement.