I have been working in the Financial Services Industry for quite some time now, and I am still learning every single day about the various things that banks can do and are doing. One of the most fascinating subjects related to Retail Banking Technology, is Fractional Reserve Banking, and in this article, I am going to share with you what it is and how it empowers banks to create a virtually unlimited supply of money.

Fractional Reserve Banking is a banking system that allows commercial banks to create money by lending out a portion of their customers’ deposits while holding only a fraction of those deposits as reserves. The central bank usually sets the reserve requirement, which is the minimum percentage of deposits that banks must hold in reserve.

Here’s a step-by-step explanation of how banks create money through Fractional Reserve Banking:

1. Customer Deposits: When a customer deposits money in a bank, the bank adds the amount to its reserve. For example, let’s say a customer deposits $1,000.
2. Reserve Requirement: Suppose the central bank has set a reserve requirement of 10%. In this case, the bank must hold $100 (10% of $1,000) in reserve and can lend out the remaining $900.
3. Lending: The bank lends out the $900 to another customer, who then spends it on goods or services. The recipient of the $900 deposit will likely deposit that money back into their bank account, either at the same bank or a different one.
4. More Lending: The bank receiving the $900 deposit must also hold 10% ($90) in reserve and can lend out the remaining $810. This process continues as money moves through the economy, with banks holding a fraction of each deposit in reserve and lending out the rest.

As this cycle continues, the total amount of money in the economy increases. It’s important to note that banks do not physically create cash; rather, they create money in the form of credit or bank deposits, which can be spent just like cash. This process is called “deposit multiplication” or “money creation.”

However, there are some limitations to the money-creation process. First, banks are constrained by the reserve requirement set by the central bank. If the reserve requirement is too high, banks may not have enough funds to lend out, limiting money creation. Second, banks must also consider the creditworthiness of borrowers, as excessive lending to high-risk borrowers can lead to defaults and financial instability. Lastly, the money creation process relies on the demand for loans; if there is low demand, money creation slows down.

Fractional Reserve Banking allows banks to create money by lending out a portion of their customers’ deposits while holding a fraction of those deposits in reserve. This process increases the money supply in the economy and enables banks to extend credit, facilitating economic growth. However, it’s crucial for banks to balance money creation with the reserve requirement, borrower creditworthiness, and loan demand to maintain financial stability.