How does the fractional reserve banking system work?

Question

I would like to understand better exactly how this works. I have heard a lot recently (particularly since the 2007-08 crash and Occupy movement) about money creation in particular (usually with a very negative bias). However, these descriptions often only go so far into it and I am curious whether it is really so bad once one has the full picture.I'd like to go through a simple example and point out where I am unsure what is actually supposed to happen.So, we have one Bank, with perhaps two customers. Alice and Bob. Alice has deposits at the Bank worth £500. Bob has £100 at this bank. A total of £600 of deposits, which the bank is liable make available to the customers at any time. The Bank has £5000 worth of its own capital. Totaling £5600 cash held (I realize that the banks' capital and the deposits are not the same - capital is an asset and deposits are a liability, for one - but this sum represents the full reserve amount, yes? The money which would be used if needed to serve depositors requests for withdrawal). We will say that the capital ratio is 10%. As I understand it, this makes the total *lendable* capital at the bank £5000 + £450 (Alice) + £90 (Bob) = £5540. I am pretty sure I am correct in my understanding so far.So, Bob owes Alice a lot of money. He needs to pay her £1000. So, he takes out a loan at 5% interest. The Bank decreases its *lendable* capital by the amount of the loan, so it can now only loan a further £4540, however it still technically possesses the full £5540 as the £1000 loan is "new" money. Naturally, Alice now deposits Bob's £1000 payment in her account. The banks total deposits now sit at £1600, the amount it is holding is now £6600. Due to the new £1000 deposit on Alice's account, £900 is added to the *lendable* capital. Making it £5440. Is this correct? So far - besides the amount of *lendable* capital against which "new" money may be created - no deductions have been made. In addition, the £1000 loan is considered an asset that the bank owns.So, now, the loan has eventually accumulated £80 interest and Bob manages to complete his payments to the bank. Bob pays the bank £1080 in total. Here is where I am most confused. What happens to this amount? I have heard people talk about "money destruction", implying that the bank quite literally throws away the £1000 originally lent to Bob. But somehow I find that hard to believe, and I am further confused because people mention removing it from circulation - presumably simply not making any use of it - as being the mechanism by which it is "destroyed". However, I do not believe it can be effectively removed completely from circulation, as the bank would surely either invest it or use it to make more loans, no? If indeed the money is not really destroyed, the bank has effectively just made £1080 out of nothng, right?Perhaps I have gone wrong somewhere in my accounting. I have a Software Engineering background so a lot of this is very new/alien to me. I am just very interested in understanding it. I feel like if something is hard to believe (such as many of the claims made about money creation) it usually is for good reason, so I just wanted to understand the full picture for myself.

Answer 1

American AP Economics tutor here. I think you are spot on about how the fractional reserve banking system creates new money through charging interest on loans.

Money “creation” and “destruction” specifically refers to changes in the Money Supply. At the high school level, we usually calculate that as Money Supply = Currency + Demand Deposits.

In fact, we can calculate exactly how much new money can potentially be created with each new deposit using something called the money multiplier. That equation is: Deposit x 1/Capital Ratio (We call it Reserve Ratio in the US)

Using your example, when Alice deposits the $1000 she got from Bob, the maximum possible increase to the Money Supply is $1000 x 1/.10 = $10,000 of “new” money that didn’t exist before. Alice deposits that $1000, the bank keeps some in reserve, then creates new loans with the rest. Because the bank has to hold some money as reserves, the amount of each new loan gets smaller and smaller from that initial $1000 deposit. You’re also correct that banks definitely don’t “destroy” any money in the way you describe in your question. Like you say, the interest from loan repayments is used to create new loans and that pattern is repeated.

Money isn’t “destroyed” in the typical sense of the word. However, it can be removed from the Money Supply. That either means its being held as reserves by banks or held by the central bank. If we had a 90% capital ratio instead of a 10% capital ratio the amount of new loans would decrease significantly. There is a lot that we could say about Monetary Policy here, but the most basic explanation is that if the central bank wants to reduce the money supply they must reduce the amount of Currency or Demand Deposits. That can be done by changing the capital ratio (reserve ratio), or targeting interest rates, or selling bonds.