Banks are required to hold 10% of deposits in bank reserves- the rest is used for investments.
When you deposit money in the bank, it’s tempting to think it all goes to a huge cash vault, or at least a huge database, with all the other deposits in a bank.
That’s not exactly how it works, however – banks are only required to hold on to a fraction of their deposit in bank reserves. In the U.S., banks with more than $79.5 million in deposits, meaning most banks, are required to keep only 10% of those deposits in reserve, according to the Federal Reserve.
The bank is free to do whatever they want to do with the rest of the money, and usually, they will lend it out to other customers.
This allows banks to “create” extra money. If you deposit $1,000, the bank has to keep $100 of it. The remaining $900 they can lend out, essentially adding an additional $900 to the money supply, since both you and the person lending the money now have $900.
Economists say the system has been vital to the development of modern society, providing capital and a method for transfer for goods and services. First invented almost 400 years ago, fractional banking has been part of Western society since.
Critics, however, say the system is vulnerable in times of economic stability, citing bank runs such as those during the Great Depression, when thousands of banks failed. A bank run occurs when multiple depositors try to get their money back, and their deposit totals are more than what the bank reserves are holding.
For example, imagine if ten depositors have $1,000 each in the bank. Even if the bank has only lent out 60% of their money, or $6,000, the bank will still fail if more than four depositors try to claim their money, because it only has $4,000 in reserves.
Bank runs have not occurred in the U.S. since the 1930s, however. Banks did start to fail during the financial crisis of 2008, but the Federal Reserve and the Federal Deposit Insurance Corporation forced the banks to merge with banks that didn’t fail, who continued operations.