Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Discovering what happens when you put your money in the bank

The best way to understand fractional reserve banking is with an example of what you might reasonably think happens to your bank deposits as opposed to what actually happens. What really happens is a lot scarier than you might think!

Imagine that today is your birthday, and you receive a clean, crisp £50 note as a present from an old friend. You consider all the exciting things you can possibly buy with your note (such as some tasty chocolates for sweet-toothed authors, perhaps?). But in the end you come to the conclusion that saving it for a rainy day would be more prudent (shame!). You take the note to your local bank branch and deposit it in your account. The cashier kindly takes your money downstairs to the bank vault for safe-keeping.

At some point in the future you need the money back (perhaps you have a date you want to impress); you return to your bank to withdraw the £50. Again the cashier goes downstairs, this time to retrieve your note, which has been faithfully waiting for you all along.

If this story doesn’t quite sound right to you, that’s because it isn’t right! What we’ve just described is known as 100 per cent reserve banking: for every pound deposited, the bank keeps exactly a pound in reserve. In fact, no modern banks use this system.

In reality, banks retain only a fraction of deposits in reserve. So when anyone deposits £50, the bank keeps only a small part (say, £5) in reserve. With the remaining £45 the bank aims to get a return on it by lending it out. The percentage kept in reserve is called the reserve ratio. In this example the reserve ratio is 5/50 = 0.1 = 10 per cent.

But if the bank has lent out most of your money, how can it possibly hope to repay you when you come to withdraw your cash? The answer lies in the fact that many different people hold accounts at the bank. At any one time, only a

few of the account holders are likely to make withdrawals. So long as the bank has sufficient reserves to cover these withdrawals, everything is fine. Problems arise when the bank’s reserves aren’t sufficient to cover the withdrawals, as you see later in the ‘Experiencing bank runs: Why any bank can fail’ section.