Appendix B — How Fractional Reserve Banking Works

Note: This section builds on insights from Appendix A: History of the Modern Fiat Currency, which explains why modern paper money has no backing in precious metals. Below, we focus on fractional reserve banking—the process that allows banks to create most of the money in circulation, often out of thin air. This practice shapes how people borrow, spend, and fall into debt cycles.

What Is Fractional Reserve Banking?

Fractional reserve banking means that when you deposit money into a bank, the bank is required to keep only a fraction of your deposit in its vaults (or “reserves”). The rest is loaned out to other people or businesses. For instance, if a bank must keep 10% of deposits in reserves, then on a $100 deposit, it can lend out $90.

But it doesn’t stop there: the person who borrows that $90 often deposits it back into another bank account—perhaps at the same bank or a different one. That second bank then keeps 10% of that $90 (i.e., $9) in reserves and loans out the remaining $81 to yet another borrower. This cycle repeats multiple times. As a result, the banking system as a whole creates significantly more money than was initially deposited.

Key Point:

The bank hasn’t physically printed bills; it simply updates computer balances. Yet it behaves as though this “new money” exists. This is one reason why the total amount of dollars in digital circulation far exceeds actual physical currency.

How Money Is Created “Out of Thin Air”

Many people think governments alone print money. While governments do produce physical cash, commercial banks generate most of the money supply through loans. Here’s a simplified example:

  1. You Deposit $10,000
    • Your bank keeps, say, $1,000 as reserves (10%) and lends out $9,000.
  2. Someone Borrows $9,000
    • They use it, for instance, as part of a home purchase. The seller receives $9,000, deposits it somewhere else, and that deposit is again partially available for loans.
  3. Loan Multiplies
    • Each time the money is re-deposited, a new loan can be issued minus the fraction held in reserve. Over several rounds, your original $10,000 deposit could theoretically support up to $100,000 in loans.

Thus, even though you see $10,000 in your savings account, portions of that deposit have been lent out to multiple borrowers. The result is a multiplied money supply—digital entries that exist only on bank computers. This is primarily the reason why banks are prone to Bank Runs.

Bank Runs

A “bank run” happens when many depositors, fearing a bank’s failure, rush to withdraw their money at once. Because banks only hold a fraction of deposits in reserve, they cannot instantly return all funds if too many customers withdraw. This panic can spread to other institutions and create systemic turmoil, reflecting the inherent fragility of a fractional reserve model. Once trust erodes, even healthy banks can face runs if depositors believe they may lose access to their money. Mitigating measures include deposit insurance and central bank interventions to reassure the public and maintain stability.

Buying a Home: A Real-World Illustration

Imagine you’re purchasing a house for $300,000, and you go to your local bank for a mortgage. If the bank decides you’re a good candidate:

  1. Loan Approval
    • You sign papers, and the bank credits your account with $300,000. It didn’t necessarily have $300,000 in a vault just for you; it only had to keep a fraction in reserve based on regulations.
  2. Money Circulates
    • You pay the homeowner $300,000. The homeowner then deposits this sum into their account (either the same bank or a different institution). From there, the cycle continues: the bank that receives the $300,000 deposit is allowed to lend out the bulk of it yet again.
  3. Inflated Money Supply
    • Because your borrowed $300,000 is now “created,” the overall money supply expands. This money, plus interest, is expected to be repaid to the bank over time.

For you, this might feel normal: “I just got a mortgage.” But from a system-wide perspective, an extra $300,000 has effectively been conjured into existence by the bank’s keystrokes.

Why There’s Never Enough Money to Pay All Interest

A major consequence of this system is that the total amount of debt always surpasses the actual money in circulation. Here’s why:

  • Banks create the principal (the initial loan amount) out of thin air.
  • However, interest is also charged, but that interest doesn’t get created in the same way.
  • Collectively, borrowers owe more money (principal + interest) than the system actually provides.
  • As a result, borrowers—individuals, businesses, or even governments—must keep taking out new loans to pay back older debts plus interest. This is why many feel they’re on a financial treadmill: working hard just to keep up with ongoing payments, or risking losing real assets if they fall behind.

Over time, if someone defaults on their mortgage or car loan, the bank can seize tangible property—real-world wealth—to recover what was essentially a digitally created sum.

Impact on Everyday Life

For most people, the effects are subtle yet significant:

  1. Debt Pressure
    • The necessity of continual borrowing means ordinary families often juggle multiple loans: mortgages, car financing, credit cards. Interest payments eat into their monthly budgets.
  2. Endless Growth Requirement
    • Economies must keep expanding (consuming, producing) to service debt. In recessions, layoffs occur and people can’t pay back loans, risking widespread default and asset repossession.
  3. Asset Loss
    • If borrowers can’t meet monthly interest plus principal, they could lose their homes, cars, or land—even though the money was initially created without tangible backing.

Why Choose Real Tangible Assets

Just as we explained in Appendix A: History of the Modern Fiat Currency, relying solely on bank-created money puts you at the mercy of inflation and ever-increasing debt. One protective measure is converting part of your savings into real, tangible assets. Examples include:

  • Gold and Silver: Historically recognized as stable stores of value that don’t rely on bank policies or fractional reserves.
  • Property or Land: While more expensive, these can appreciate over time and have intrinsic use.
  • Staple Goods: In certain community-based riba-free models, storing essential commodities (e.g., rice) can hedge against currency devaluation.

By diversifying beyond purely paper or digital money, you reduce the risk of losing everything if debts mount, interest costs surge, or currency values drop.

Conclusion

Fractional reserve banking allows commercial banks to create money through loans far exceeding the actual deposits they hold in reserve. While this fuels economic activity, it also inflates the total amount of money owed (principal plus interest) beyond what physically exists, pressuring borrowers to either keep paying or risk forfeiting real assets.

For everyday individuals, this can feel like a never-ending chase to stay ahead of interest payments. Recognizing how new money is conjured by commercial banks—and the vulnerabilities it creates—can guide you toward safer financial habits. By saving in real assets such as gold, silver, or property, you insulate part of your wealth from the pitfalls of fractional reserve inflation and the riba-driven system, paving the way for greater financial security and peace of mind.