How the Fractional Reserve System Works

    By Alistair McConnachie

    This article is intended to provide Money Reformers with important background information on the fractional reserve system – and which may help them if they have to explain it at length in any kind of public situation. The explanations which we’ve extracted from the textbooks below, are clear and concise and are the best and most helpful summaries we’ve read, to date.

    However, it is not always necessary to explain this material in front of an audience. Sometimes it can have the potential to “derail the narrative”. Just when you’re getting on fine explaining Money Reform, one risks confusing people with the technical explanations. So, we don’t always want to “go there” with an audience.

    Photocopies of these pages will be sufficient, while pointing out the truth that: “By the mechanism of making loans and creating deposits, banks manufacture new money, effectively, ‘out of nothing’.” That is all that usually requires to be said. However, if you need it, this in-depth article provides more background.

    We have also been moved to write this article because we recently encountered an article in a far-left magazine(1) which has a history of being hostile to the Money Reform analysis. We started to hear about this magazine’s hostility, and document it, when we started to publish Prosperity – 9 years ago!

    This magazine appears to be dreaming about a society where there is no need for money at all!(2) As we said in our publication Clarifying our Money Reform Proposals, and we will say again, because it is 100% relevant in this instance:

    People will always need to exchange. Money will always be with us. The “moneyless world” people are living in an irrelevant fantasyland, divorced from reality.

    Anyone can imagine a perfect world. Anyone can dream of utopia. It’s much harder, but more constructive, to get to grips with reality and to try to create something useful out of the facts of our physical existence.(3)

    Anyway, the question is, what are these people saying which is trying to get in our way? They are saying that:

    1) A bank can lend out a fraction of what is deposited with it.
    2) When it does this, it does not “create new money”, and
    3) a bank current account does not represent new money.
    4) A bank cannot lend out a multiple of a deposit.

    The first proposition is correct, the other three are wrong. Let us take the first point: Yes, it is true that a bank can lend out a fraction of what is deposited. Here’s how it works:

    Imagine you deposit £100 cash with a bank. Let us say that the reserve ratio is 10%, for ease of calculation. That means – and this is the first method – that when you make a deposit of £100 with a bank then the bank can keep back £10 and lend out £90 of that money. It is lending out a percentage of real money that has been deposited with it.

    That £90 finds its way to another person who takes that £90 and deposits it in another bank. That other bank takes the £90, keeps back 10% which is £9, and lends out £81, which goes to another person, who takes that £81 and deposits it in a bank which keeps back £8.10 and lends out £72.90, and so on…until there is nothing left to deposit and lend out.

    Now, the naysayers will bring up their second point and tell us that no new money is created by this method, because this is just the same £100 going round and round, and in a way we can see how they make this mistake.

    For example, if there were no banks involved in the system, and there were just individuals exchanging with each other, then my £100 would translate into a physical loan of £90 to you, leaving me with only £10 in my pocket. You could keep back £9 of that £90 and lend out £81, and so on. It would just be the same physical £100 going round and round – no new money would be created!

    However, the introduction of banks and their current accounts changes everything! How so?

    Because an amount equivalent to my initial deposit of £100 still exists in full with the original bank and I can withdraw £100 from it right now! An amount equivalent to the second person’s deposit of £90 still exists in full with the second bank and he can withdraw £90 right now. Similarly, the third person’s deposit of £81 still exists in full with the third bank, and he can withdraw £81 right now, and so on, right through the system – until there is a running total of £900 worth of new deposits which, theoretically can be drawn upon and spent, right now!

    All of these deposits, including my initial deposit, total £1000 worth of money! These are all deposits which can now be drawn upon, and from which a total of £1000 worth of money can be extracted.

    Therefore, my original £100, has given rise to £900 of new money in the system!

    At this stage, our detractors raise their third point. These bank deposits, they say, are not a form of money.

    After all, they say, there is not £1000 of real money – like notes and coins – in these deposits and if everyone tried to take out their money, it would not be there. There is, they say, only the original £100 of cash, and the rest is just “numbers”.

    However, in practice, they are wrong. In practice, if everyone in this chain tried to take out their deposits – that is, tried to take out money to the limit of £1000 – then, if there were not sufficient cash – notes and coins – available, the bank would simply write you a cheque, or transfer the equivalent sum electronically to another of your accounts. Therefore, you will get your full sum of money, in some form, whatever happens! (Bank failures excepted, of course!)

    In short, it is obvious that a bank current account is money, and that the account is fully redeemable for whatever sum is deposited within it. These bank current accounts (sometimes called sight deposits) – those which enable immediate withdrawals via cash machines, cheque-books or plastic – are clearly a form of money in our modern society!

    So, the first two ways in which the naysayers are wrong is that they don’t accept that banks create new money every time they create a new current account deposit and that these current account deposits are a form of money!


    The third way in which these people are wrong – and our fourth point above – is that they don’t accept that the fractional reserve system is actually more sophisticated than they imagine.

    That is, the fractional reserve system allows, not just a fraction of the money deposited to be relent, as above, but also a multiple of the money deposited to be created!

    If a bank can keep back, say, 10% of a £100 deposit (which is £10) and lend out the remaining 90% then it can also ask, “of what amount does £100 represent 10%” (and the answer is £1000).

    Therefore, if the bank keeps back the £10 in order to satisfy the cash demands of the depositor of the initial £100, then it can use the remaining £90 of the deposit to make a loan of £900. Total deposits in the system, as a result of the initial deposit of £100, now equal (£100 + £900) £1000. This is safe banking because the initial depositor of the £100 will only ever ask for £10 cash, and the person with the loan of £900 will only ever ask for £90 cash – both sums adding up to £100, which represents the exact amount of cash available from the initial £100 deposit.

    Consequently, a deposit of £100 can give rise to a loan of £900 and ultimately, as per the method described above, an additional £9,000 of new bank-deposit created money – or even more, as per the method described below!

    At this point, some naysayers will flatly refuse to accept that this is how the fractional reserve system can work! However, there is enough academic material out there to show that this, indeed, does happen. For example, in the February 2002 issue of Prosperity we quoted from Derek Lobley’s economics textbook, which detailed this exact point and wherein he said:

    If the bank discovers that, at the most, the weekly withdrawal of cash amounts to 10 per cent of total deposits, and that this is quickly re-deposited by traders accepting cash payments from customers, then the most cash the bank needs to meet demands from its customers with deposits of £10,000 is actually only £1000.

    Alternatively we may take the view that with cash in hand of £10,000 the bank can afford liabilities of £100,000.(4)

    Below is another academic reference which backs up the proposition that banks do operate this way. It is copied verbatim from the paperback book Money and Banking Made Simple (5), part of the Heinemann “Made Simple Books” series. This book was, according to its Foreword, “specifically designed to cover the syllabus requirements of the Institute of Bankers Stage II examination in Applied Economics”. All headings, paragraphs and emphases as per the original. Verbatim extract begins at Chapter 1, page 6:

    The Creation of Credit
    The growth of banking as a system for taking care of money was soon supplemented by a more profitable activity. The early goldsmiths had noticed that only a very small proportion, about 8 per cent, of the funds of each depositor was in use regularly, being drawn out and paid in as funds were used or received. The proportion left on permanent deposit was about 92 per cent of the average depositor’s funds. It seemed sensible to lend some of this money to people anxious to borrow for industrial and commercial reasons.

    However, in lending out these surplus funds the banks took a more sophisticated view of the unused balances than merely to regard them as funds available for lending. Consider a deposit of £100, of which only £8 is likely to be required to meet the customer’s needs, and the balance of £92 is available. The banks did not regard this as £92 available to lend to customers, but as the cash ratio for loans to a much greater sum. Of what sum is £92 eight per cent? The answer is:

    £92 ÷ 8 x 100 = £1150

    In theory the bank could lend a customer £1150. The customer has borrowed the money to spend, so let us pretend that in the eighteenth century he bought a herd of cattle for £1150. The vendor of the cattle would not know that the money was a pure invention, and would pay the cheque for £1150 into his account, but the statistical probability was that he would only then ask for 8 per cent of it, i.e. £92–the exact sum which the bank has available. We therefore see that ‘loans make deposits’ and also make profits for the bank. If the rate of interest was 10 per cent, and the loan was for one year, the interest earned would be £115, more than the original deposit which made the loan possible. The whole process is usually called the creation of credit or the creation of money.

    This is of course an extreme example, for to rely entirely on the statistical probability might prove disastrous at certain times. For greater prudence the banks usually kept a liquidity ratio nearer to one third, so that a deposit of £100 would act as a liquidity ratio for total deposits of £300. This means that loans of £200 could safely be made, the other £100 being the deposit already received. While this would rarely put the banks in difficulties, at times of real national disaster the only thing to do was to close the banks, as those old enough to remember the start of either of the World Wars will recall. The first act of the Government on the declaration of war was to shut the banks, to prevent depositors drawing out money which in fact was not available.(6)

    The authors revisit this subject in Chapter 6, as per below:

    6.2 Banks and the Creation of Credit
    The definitions of ‘money supply’ given in Chapter 1 have already suggested that money in a modern economy is not confined to notes and coin alone. In particular, the banking sector in most economies is able to create its own money: bank credit, commonly known as ‘advances’. Banks are able to make advances by creating deposits. Thus if a banker agrees to make A an advance of £500 he credits the amount in A’s current account as if A has deposited that sum. Of course he also opens a loan account for the same amount in A’s name, which will be repaid in some agreed manner in due course, with interest. This does not affect the fact that A is able to use a cheque book to purchase whatever he requires up to the figure of £500 and it is a sign of the general faith in the banking system in the UK that those who take A’s cheques in settlement of his debts are quite happy to deposit them in their own bank accounts. The deposits therefore continue to exist after their initial creation, instead of being exchanged for some preferable alternative, such as cash. That holders of deposits do not attempt to turn them into cash indicates that businessmen and the public in general are prepared to accept the settlement of debts by the transfer of deposits–by the use of cheques. There is therefore no need to make a mass movement from deposits to cash.

    Bank deposits become ‘credit’ balances which a banker owes to his customers. Deposits will be owed because the banker has taken something from the depositor–currency, another bank deposit, securities (e.g. Treasury bills) or a claim upon the customer.

    Where a banker builds up deposits in exchange for cash or other deposits the deposit creation is said to be passive since there is no net effect upon the supply of money. Where the deposits are created as a result of advances made against securities or a claim upon the customer, these creations are termed active, since there will be a net addition to the money supply.

    …[here we’ve removed a para from this verbatim extract]

    The ability of banks to engage in active deposit creation rests upon public confidence in bank transfers as a method of payment. Because the public has confidence in the banking system only a small proportion of the claims upon banks are ever requested in the form of cash (on average about 5 per cent today). This means that, providing banks can continue to attract a small proportion of their deposits in cash form, they can theoretically create massive active deposits.

    To repeat the historical example given in Chapter 1, [as Prosperity has quoted above] but with the more modern cash ratio of 5 per cent, suppose a customer deposits £100 in cash (of which he is only likely to request £5 back); this £100 is 5 per cent of £2000. The bank could therefore in theory create £1900 of credit, by making advances to borrowers of that amount. This £1900 would be paid out by borrowers using cheques, and these cheques would return as deposits to the banking system by the traders who received them. Since these traders will only have a 5 per cent cash ratio, they are unlikely to ask for more than 5 per cent of £1900 = £95, which is precisely the amount of cash available.(7)

    < end of extracts


    The following is another example copied verbatim from the paperback book Elements of Banking Made Simple(8), also part of the Heinemann “Made Simple Books” series. This book was, according to its Preface, “specifically designed to meet the requirements of the Institute of Bankers’ Banking Certificate and Foundation Courses, and the BTEC National Certificate in Business and Finance”. This is the 1989 edition and the figure of 30%, used in the example, can be considered somewhat conservative these days! Again, all headings, paragraphs and emphases as per the original. Verbatim extract begins at page 19:

    2.6 How the banks create money: the creation of credit
    We have seen that the funds available to ordinary members of the public in their current accounts are part of the money stock, since they are freely available to spend as the customers think fit, using a cheque to make the payment. Sometimes called ‘near money’ because they are not actually coins of the realm or banknotes, these deposits are credited to the customers’ accounts. Book-keeping students will appreciate that they are credit entries because the bank concerned owes the money deposited back to the depositors, who are therefore creditors of the bank. The trouble is that much of these credits never were coins or banknotes, but are solely the result of the bank’s ‘credit creation’ activities. When a bank makes a loan to a customer it puts the money it is making available on the credit side of the customer’s account, and opens a loan account in the customer’s name with a debit balance for the same amount. These two accounts may be said to neutralize one another in the bank’s Balance Sheet. However, the customer has borrowed the money for some purpose, and soon draws cheques to the agreed value, which are spent with various suppliers. These suppliers have no idea that the money is purely ‘created’ by the bank, and pay the cheques in as further deposits, which they believe to represent real coins and notes. We thus have credit entries in these suppliers’ accounts which are ‘created’ credits – and a well-known banking doctrine ‘loans make deposits’ has been illustrated once again.

    Banks are in business to make profits, and they do so by making loans on which they charge interest. How much they lend out depends upon the deposits paid in, and the probable need to repay money to depositors who wish to recover liquidity. The actual probability of any particular depositor requiring his or her money back is about 5 per cent, but the banks pursue a cautious policy and the general tendency is to keep about 30 per cent of assets in cash or near-cash form. Some of this 30 per cent may be out on loan to reliable customers (the discount houses and gilt-edged dealers) at call or short notice, but the whole 30 per cent is readily available to meet the needs of depositors. The other 70 per cent is available for making loans.

    Let us consider the possibilities for lending money from that 70 per cent. To illustrate the problem we will consider a deposit by Mrs A of a genuine sum of money, £1000 in banknotes and coins. The possibilities are as follows:

    (a) We can lend out £700, since we are keeping 30 per cent of the deposit (£300) in liquid form. This is the simple view of bank lending.
    (b) We can ask ourselves ‘Of what sum of money does £1000 represent 30 per cent?’ The answer is £3333.33. It is therefore possible for us to have deposits of £3333.33. As we only have deposits (from Mrs A) of £1000 we can lend out £2333.33, provided we can find borrowers. This is the more sophisticated view of bank lending.

    It may seem miraculous to be able to lend out £2333.33 based upon a deposit of only £1000, but it is perfectly safe. If we lend Mr B £2333.33 and he spends it all with Messrs C, they will pay it in as a deposit. We now have deposits of £3333.33, and we have £1000 of real money. If Mrs A asks for the return of 30 per cent of her deposit we can give her £300, and if Messrs C asks us for 30 per cent of £2333.33 we can give them £700. (Actually even this money will be out on loan to the discount houses at call or short notice.) The probability is that they will ask for only 5 per cent, so we are really quite safe. Meanwhile Mr B is paying us 14 per cent of £2333.33 in interest, which is £326.66 per annum.(9)

    < end of extract

    It could be argued that the process by which new bank deposits create new money in the system is just a quirk of its operation, and “just the way it works”. So what, if anything, can be done to stop this process?

    Huber and Robertson recognise this point and explain the solution in their book Creating New Money(10). Our emphases:

    The second thing that needs to be achieved by seigniorage reform is to stop the creation of sight deposits by the commercial banking sector. Within the current reserve system, banks cannot be prevented from creating them – partly because of the technicalities of the existing conventions of bank accounting(11)…The solution is, in fact, simpler than those past proposals suggest. It follows directly from declaring sight deposits to be legal tender. It is to take bank customers’ current accounts off bank balance sheets, and recognise formally what they now actually are: accounts containing non-cash money which belongs to customers, just as customers’ wallets and purses contain cash money that belongs to them. In other words, customers’ current accounts will cease to be accounts belonging to the banks. They will be containers of money belonging exclusively to bank customers(12)…By detaching current accounts from the banks’ balance sheet, the problem of how to prevent banks from creating non-cash money will be solved. Banks need not be forbidden to create sight deposits. They will no longer be able to.(13)

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    (1) Adam Buick, “Banks, money and thin air”, socialist standard, January 2009, pp.12-14.
    (2) Janet Surman, “Five more benefits of not having money: We continue describing how things could be like in a socialist society, where there would be no need for money”, socialist standard, January 2009, pp.17-18.
    (3) Written and compiled by Alistair McConnachie, Clarifying our Money Reform Proposals: A Report for the Tenth Annual Bromsgrove Conference, (Glasgow: Bromsgrove Briefing, 2006) at p.15.
    (4)  Derek Lobley BA, Success in Economics, (London: John Murray Publishers Ltd, 1978 edition), pp.205-206, and published in “How Banks Create Money out of Nothing” Prosperity, February 2002, p.4.
    (5) Ken Hoyle, BSc (Econ) and Geoffrey Whitehead, BSc (Econ), Money and Banking Made Simple, (London: Heinemann, 1982).
    (6) Ibid at Chapter 1, p.6
    (7) Ibid at Chapter 6, pp.89 and 92 (pages 90 and 91 are diagrams).
    (8)  Julia Hoyle, ACIB and Geoffrey Whitehead, BSc (Econ), Elements of Banking Made Simple, (Oxford: Heinemann, 1989 edition).
    (9) Ibid at pp.19 and 22 (pages 20 and 21 are diagrams).
    (10) Joseph Huber and James Robertson, Creating New Money: A monetary reform for the information age, (London: New Economics Foundation, 2000), pp.22-28. Available for free download at
    (11) Ibid at p.22.
    (12) Ibid at pp.23-24.
    (13) Ibid at p.24.