When you deposit money into your bank account, the bank does not simply hide the funds in a cash cow in the basement or elsewhere. Instead, it lends your capital to the people or companies that need it. Thanks to the fractional reserve banking system, when the bank lends your money to others, it actually generates money.
Fractional reserve banking
In today’s banking system, when depositors want to withdraw their deposits, banks are only required to keep a small portion of these deposits with them. but why? Why don’t banks keep all our money with us?
The Federal Reserve, the US Federal Reserve, explains:
The fact that banks are required to store only part of their deposited capital is one of the tenets of the banking profession. Banks borrow money from their depositors (from the ones they save in the bank) and instead lend it to the applicant.
Banks get more money (higher interest rates) from the borrower than the cash money on the loan. If banks do not lend to others after they have secured the required reserves, depositors will have to pay banks to maintain their funds. In sum, maintaining only part of the deposits will be very effective for the economy and banking system. A fractional reserve system allows banks to make money.
How does fractional reserve banking work?
When you deposit your money in the bank, the bank is required to keep a certain amount or a percentage of that money, but it can lend the rest of the money to the applicants.
For example, if you deposit $ 100,000 into the bank and the bank’s deposit rate is 10%, the bank will have to deposit $ 10,000 of your own money and lend the remaining $ 90,000 to the applicants.
In principle, the bank gets $ 100,000 and converts that money into your account and then lends the remaining $ 90,000 to another person for $ 190,000. Similarly, if you go ahead, you will see that your initial $ 100,000 with a 10% saving rate will eventually convert to $.
The process will be as follows:
|Your deposit||$ 100,000||The amount of loan your bank gives to another person||$ 90,000|
|Borrower’s deposit||$ 90,000||The amount of loan the bank gives to another person||$ 81,000|
|Borrower’s deposit||$ 81,000||The amount of loan the bank gives to another person||$ 72,900|
|Borrower’s deposit||$ 72,900||The amount of loan the bank gives to another person||$ 65,610|
|Borrower’s deposit||$ 65,610||The amount of loan the bank gives to another person||$ 59,049|
|Borrower’s deposit||$ 59,049||The amount of loan the bank gives to another person||$ 53,144|
|Borrower’s deposit||$ 53,144||The amount of loan the bank gives to another person||$ 47,829|
And so on.
Eventually, your initial $ 100,000 will be converted to $ 1 million at a 10% saving rate.
To find out exactly how much money your franchisee can deposit in the theory of fractional reserve banking, use the Monetary Incremental Equation:
Total Money Produced: Initial Deposit x (1/Reserve Rate)
For example, if we were to solve the equation with the numbers above, we would have:
(1 / 0.01) * $ 100,000 = $ 1,000,000