Fractional Reserve Banking

Fractional Reserve Banking refers to a banking system which requires the commercial banks to keep only portion of the money deposited with them as reserves. The bank pays interest on all deposits made by its customers and uses the deposited money to make new loans. In order to understand how fractional reserve banking works, let's look at the following example.

Somebody deposits $1,000 with Bank A. Bank A is obligated by law to keep 10% of the deposited money as a reserve, that's why the bank keeps $100 and lends out $900. Somewhere down the road the $900 loan is deposited in another chequing account (it might or might not be with the same bank). This second bank also wants to make money by giving out loans, that's why it keeps the required $90 and lends $810. Fast forward to a deposit with a fourth bank and you'll get the following:

Bank #1$1,000$100$900
Bank #2$900$90$810
Bank #3$810$81$729
Bank #4$729$729$0

As you can see from the table above, the banks created $2,439 based on the first $1,000 deposited. The fractional reserve banking works, because the total amount of withdrawals is offset by deposits made at the same time. While the depositors are confident at the fractional-reserve banking system, a very small part of all deposits is withdrawn at the same time allowing the banks to handle the withdrawals through their reserves. However when there's economic crisis and confidence is shaken, the entire banking and financial system can be at risk.

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