In the United States, the US Federal Reserve sets a reserve requirement for commercial banks. It tells the banks what percent of deposits, they must keep in their vaults. The remainder of the deposits the bank can lend out. Currently, the reserve requirement for banks are:
0% for a bank with less than $12.4 million in deposits
3% for banks with $12.4 million to $79.5 million
10% for banks with over $79.5 million.
For example, if one person deposits $1,000 into a bank with a 10% reserve requirement, that bank has to keep $100 in reserves. It can then lend out $900 to borrowers.
The borrower spends the $810, which gets deposited into the bank of the person who earns the money, and the bank holds 10% ($81) of that deposit in reserves. The bank can then lend out the remaining $729.
And so on, until the bank can no longer lend out more money. At the end of the process, the total amount of money that has been deposited into the bank by all the storeowners (and the original depositor) adds up to $10,000.
But, wait a minute. Didn't we start out with only a deposit of $1,000? And isn't it just the same money being lent out and then re-deposited into the bank?
Why, yes! Through the bank lending part of the initial $1,000 and then re-lending that money to others when it comes back through the banking system (once it has been spent), we manage to increase deposits from $1,000 to $10,000.
This is known as the money multiplier. Through fractional reserve banking, a small original deposit can turn into ten times the amount of deposits. The money is multiplied (leveraged).
Money is literally created out of thin air through the lending process and the banks' balance sheets.
At the end, we have:
- $1,000 Original Deposit
- $9,000 Lent Out
- $9,000 Re-Deposited
- $1,000 in Reserves
So, what would happen if all these store-owners try to collect their deposits? The money is not there.
Now, typically, a bank keeps more in reserves than the minimum required by the Federal Reserve (this lowers the money multiplier.) Banks do this precisely because they know that depositors will demand (and spend) bits of their money at a time, and the banks want enough liquidity (cash on hand) to be able to meet these demands.
The less risk a bank wants to take on, the more they will keep in their reserves and the less they will lend out, since the banks want to avoid what is known as a bank run, where depositors try to take out money that the bank does not actually have. But, while banks have incentive to keep money in reserves for liquidity purposes, they also have incentive to lend out as much as they can because they make interest from those loans.
Banks have to find a balance between liquidity and lending.
Lending can be wonderful thing. It may provide start-up businesses with the funds they may need to get off the ground. And, when banks are held accountable for the money they lend out to borrowers, the banks have incentive to make sure the funds are going to people who have good financial histories and prospects. As mentioned before, banks may also keep more in reserves than required by the Fed, in order to have enough funds available for withdrawal. The bank is relatively cautious when it is ultimately responsible to the depositors for their funds.
However, BIG problems arise when the bank is not held responsible for the money it lends out.
The banking system is highly intertwined: money borrowed from one bank may be deposited into another, which then gets lent out, and that lent out money may be deposited in still another bank. So, when depositors ask for their funds, and a bank is insolvent (can not pay the money), other banks may also be at risk.
The system only works to the extent that people have trust in it, but it can crumble like a house of cards when stressed. Since the Federal Government wants to protect the banking system from potential stress, they provide FDIC insurance. The Federal Reserve also acts as a lender of last resorts; It will provide loans to a bank to cover liquidity issues. On top of this, the Federal Government (US Taxpayer) also has a tendency to bailout insolvent banks in order to preserve the system and stop it from collapsing. In this situation, the Federal Government absolves the banks from responsibility to their depositors, which only encourages the banks to engage in more risk lending.
And build a bigger house of cards.