Under the Hood: The US Fractional Reserve Banking System

Centuries ago, people would leave their extra gold and coins on deposit with the local goldsmith until it was needed. Years later, deposit receipts were used since they were easier to carry. However, because the majority of bank deposits would sit idle until needed, and to avoid charging a fee to depositors for safeguarding their money, banks began to use deposits to make loans. Outstanding loans, however, are much greater than total deposits. This is the genesis of our fractional reserve banking system. 

How Money Is Created and Leveraged

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

The table below illustrates more precisely how this process works. To begin, let's assume the Fed purchases $10,000 in newly issued government securities. The Fed would deposit this money in the securities dealer's bank account, which we'll refer to as Bank A.

Assuming a 10% reserve requirement exists on all deposits, Bank A would allocate $1,000 to reserves ($10,000 x 10%) which would leave $9,000 to loan or invest. Therefore, in Expansion Stage 1 (see Table A below), the $10,000 would be reduced by $1,000, leaving $9,000 as free capital or excess reserves. Eventually, the $9,000 would be loaned and deposited by the borrower.

Again, after accounting for its reserve requirement, the bank receiving the deposit would have excess reserves of $8,100 (see Expansion Stage 2). This process is repeated approximately 74 times until the final stage occurs and the excess reserves are at zero.

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

How much leverage is possible using the amount of Treasuries actually purchased by the Fed? Using data from 2013, the Fed bought $759 billion in U.S. Treasuries. Assuming the same 10% reserve requirement, the total monetary expansion would be in excess of $6.83 trillion ($759 billion x 9).

Of course, this assumes banks are eager to lend and borrowers have an appetite for borrowing. It's rarely this simple.

Current Reserve Requirements

It should be noted that cash in the vault plus reserves held by the Federal Reserve Bank constitute bank reserve requirements. The Federal Reserve Board announced its 2015 reserve requirements on November 14, 2014. They are listed in the following table. 

In addition to reducing interest rates and expanding the money supply during the 2008-2009 financial crisis, the Fed also reduced its reserve requirements to make additional capital available for lending. Since late 2008, the Federal Reserve has been paying interest on required reserve balances and excess balances. 

Conclusion

The Federal Reserve has many tools at its disposal to help guide the U.S. economy. We've just discussed one which is lesser known but vitally important. Even though 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, next time you make that bank deposit, multiply it by nine and consider that this is the approximate amount of additional capital your deposit will facilitate.