How Money is Made: Fractional Reserve Banking

If you ask the average person where money comes from, they'll likely say "the government prints it." While the government does print physical bills, they only account for a tiny fraction of the total money in our economy. The vast majority of the money you use every day—the numbers in your bank account—was actually created by commercial banks.

Understanding how this happens is the key to understanding the modern financial world.

The Magic of the Loan

When you go to a bank to get a £10,000 loan, the bank doesn't take £10,000 out of a vault or deduct it from someone else's account. Instead, they simply type "£10,000" into your account.

In that moment, new money has been created. It didn't exist a second ago, and now it does. The bank has created a liability for itself (the money in your account) and an asset (your promise to pay them back with interest).

The Theory: Fractional Reserve Banking

Historically, this system was known as "Fractional Reserve Banking." It's based on the same principle the London goldsmiths discovered: as long as everyone doesn't try to withdraw their money at the same time, the bank only needs to keep a small "fraction" of its total deposits in reserve.

In many textbooks, this is explained using a "money multiplier" model: if a bank has £1,000 in reserves, it can lend out £10,000, which then gets deposited elsewhere and lent again. While this helps explain the concept of credit creation, it isn't actually how the modern Bank of England system works.

The Reality: Modern Money Creation

In the UK, the Bank of England does not set a mandatory "reserve ratio." Banks don't wait for deposits before they lend. Instead, the act of lending creates the deposit.

If the bank doesn't have a 10% limit, what stops them from printing infinite money? The "actual rules" are based on three main constraints:

1. Capital Requirements: This is the most important rule. The Prudential Regulation Authority (PRA) requires banks to hold a certain amount of "capital" (essentially their own skin in the game, like equity and retained profits) against their loans. If a bank wants to lend more, it must have enough capital to absorb potential losses.
2. Liquidity Coverage Ratio (LCR): Banks must hold enough "High-Quality Liquid Assets" (like cash and government bonds) to survive a 30-day period of extreme stress (a modern bank run).
3. The Bank of England's Interest Rate: By changing the interest rate, the BoE makes it more or less expensive for banks to borrow the reserves they need to settle transactions with each other. This indirectly controls how much banks want to lend.

As the Bank of England itself stated in a landmark 2014 paper: "Money creation in practice differs from some popular misconceptions—banks do not act simply as intermediaries, lending out deposits that savers place with them."

Money is Debt

In our modern system, nearly all money is created as debt. If every person and every government in the world paid off all their debts tomorrow, there would be almost no money left in circulation.

This creates a strange and counter-intuitive reality: for the economy to grow and for the money supply to expand, someone, somewhere, must be getting further into debt.

Why This Matters to You

Fractional reserve banking is a powerful engine for economic growth, but it is also inherently unstable. It relies entirely on trust. If people lose confidence in a bank and all try to withdraw their money at once (a "bank run"), the bank will fail because it simply doesn't have the physical cash to satisfy everyone.

This is why governments provide deposit insurance (like the FSCS in the UK) and why central banks act as "lenders of last resort." They exist to prevent the collapse of this delicate web of digital promises.

In our final article of this series, we'll look at the mathematical consequences of this debt-based system: why inflation and interest make periodic "bankruptcies" an unavoidable necessity.