Reserve banking

Under the Hood: America’s Fractional Reserve Banking System

How money is created and used

In the US fractional reserve banking system, banks are required to keep a fraction of their deposits in reserve but may lend or invest the rest of the money (i.e. excess reserves) for prudent business purposes. . This leverage explains how $ 10,000 in new deposits can ultimately generate up to $ 90,000 in additional capital.

The table below illustrates more precisely how this process works. For starters, suppose the Fed purchases $ 10,000 in newly issued government securities. The Fed would deposit this money into the bank account of the stockbroker, which we will call Bank A.

Assuming there is a 10% reserve requirement on all deposits, Bank A would allocate $ 1,000 to reserves ($ 10,000 x 10%), leaving $ 9,000 to lend or invest. Therefore, in expansion step 1 (see Table A below), the $ 10,000 would be reduced by $ 1,000, leaving $ 9,000 as free capital or excess reserves. Ultimately, the $ 9,000 would be loaned and deposited by the borrower.

Again, after factoring in its reserve requirements, the bank receiving the deposit would have excess reserves of $ 8,100 (see expansion step 2). This process is repeated approximately 74 times until the final step occurs and the excess reserves are at zero.

Again, the initial $ 10,000 that entered the monetary system as fresh money can generate about $ 90,000 in additional capital.

What leverage is possible using the amount of treasury bills actually purchased by the Fed? Using data from 2013, the Fed bought $ 759 billion in US Treasuries. Assuming the same 10% reserve requirement, total monetary expansion would exceed $ 6.83 trillion ($ 759 billion x 9).

Of course, this assumes that banks are willing to lend and borrowers are willing to borrow. It is rarely that simple.

Current reserve requirements

It should be noted that the money in the safe more the reserves held by the Federal Reserve Bank constitute the minimum reserves of the banks. The Federal Reserve Board announced its reserve requirements for 2015 on November 14, 2014. They are listed in the following table.

Bank reserve requirements

In addition to cutting interest rates and increasing the money supply during the 2008-2009 financial crisis, the Fed also reduced its reserve requirements to make additional capital available for loans. Since the end of 2008, the Federal Reserve has been paying interest on minimum reserve balances and excess balances.

Conclusion

The Federal Reserve has many tools at its disposal to help guide the US economy. We have just discussed one that is less well known but vitally important. While the potential monetary expansion may be large in a fractional reserve banking system, if banks are unwilling to lend and borrowers are unwilling to borrow, the benefits would be negligible. Therefore, the next time you make that bank deposit, multiply it by nine and consider that this is the approximate amount of additional capital that your deposit will facilitate.


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