Fractional Reserve Banking: How Banks Really Create Money

Fractional reserve banking is a system in which banks keep only a fraction of their customers' deposits as cash or central bank reserves, and lend or invest the rest. That is the textbook definition. In practice, the Bank of England explains, it works the other way round: “bank lending creates deposits”. And in the United States, the fraction banks are required to hold has been zero since March 2020 (Federal Reserve).

It matters because it explains where most money comes from, why a bank can fail when its depositors all ask at once, and why bitcoin was built so that no one can create it by lending.

How fractional reserve banking works in the textbook

The textbook story starts with a deposit. You pay $1,000 into a bank, which must keep a fixed share as reserves. Until March 2020 the Federal Reserve really did require 10% on checking-account balances above a threshold (Federal Reserve), so take that as the share. The bank keeps $100 and lends out $900.

The borrower spends the $900, the seller pays it into another bank, and that bank keeps 10% and lends out the rest. Round after round, the original $1,000 can support up to $10,000 of deposits in total: the first $1,000, plus $9,000 of new money created by lending.

The money multiplier

The ratio between the two is the money multiplier, one divided by the reserve ratio: at 10%, it is 10. In this model the central bank controls the amount of money by controlling the amount of reserves, and the multiplier does the rest. Some economics textbooks still introduce banking this way.

How banks really create money

Central banks say the textbook has the order backwards. When a bank makes a loan, it credits the borrower's account with a new deposit, and new money exists from that moment. The bank does not need a saver's deposit first: the Bank of England says this turns the textbook sequence on its head.

The same paper says the money multiplier is “not an accurate description of how money is created in reality”. Reserves do not limit lending. Banks decide how much to lend according to the profitable opportunities they see, which depend crucially on the interest rate the central bank sets. The deposits follow, and the central bank then supplies the reserves that banks need to settle payments with each other.

Repayment works in reverse. When a loan is repaid, the deposit used to repay it disappears. In the Bank of England's words, “the repayment of bank loans destroys money”.

So most money is made by banks. In the UK, 97% of the money the public held was bank deposits in December 2013. In the US in August 2026, notes and coins were $2.39 trillion of a $23.34 trillion money supply (M2), about 10% (Federal Reserve). The rest was bank deposits and money market funds.

How fiat money is actually created →

Does the US still use fractional reserve banking?

In practice, yes; by rule, no. On 15 March 2020 the Federal Reserve cut its reserve requirement ratios to zero, effective 26 March. In its own words, the change “eliminated reserve requirements for all depository institutions”. It released an estimated $200 billion of required reserves. The Fed said reserve requirements no longer played a significant role in its framework, which keeps ample reserves in the banking system (Federal Reserve).

The UK has no reserve requirement either. The Bank of England said in 2014 that it had “no formal reserve requirements”, and its current operating procedures (June 2026) say banks' reserve balances “can be varied freely” to meet day-to-day needs.

Banks still hold reserves, because they need them to settle payments with each other and to meet liquidity rules. In August 2026 US banks held $2.94 trillion of reserves at the Fed, against $19.11 trillion of the deposits counted in M2: about 15 cents for every dollar (Federal Reserve). The fraction is now a business decision, not a legal minimum.

What limits how much money banks can create?

If reserves do not limit lending, something else must. The Bank of England lists several brakes:

Profit and competition: a bank has to find borrowers it expects to repay, at interest rates that still win their business.
Capital rules: under Basel III, a bank's Tier 1 capital must be at least 3% of its total exposures at all times (Basel Committee). That still allows total exposures of up to about 33 times its capital, funded mostly by borrowed money, deposits included.
Liquidity rules: a bank must hold enough high-quality liquid assets to cover its expected outflows over 30 days of stress, a liquidity coverage ratio of at least 100% (Basel Committee).
Borrowers' choices: households and firms can pay down debt, which destroys money.
Monetary policy: in normal times, the central bank's interest rate, which the Bank of England describes as the final brake on money creation.

None of these is a fixed ceiling on the amount of money. Capital can be raised, rules can be relaxed, and interest rates are set by a committee. The money supply is the running total of millions of lending and repayment decisions.

Who controls the money supply? →

Why fractional reserves make banks fragile

A bank's deposits are payable on demand, but its loans are repaid over years. On most days that is fine, because only a few depositors want their money at once. If many want it on the same day, no bank can pay them all from its own reserves.

The mainstream answer is a set of backstops: deposit insurance, so that small savers have no reason to run, and a central bank that lends to sound banks in a panic. Most of the time they work. When they are not enough, governments either rescue the bank or, under newer rules, make its shareholders and larger creditors take the losses.

What is a bank run? Northern Rock, SVB and the bail-in →

Can bitcoin be fractionally reserved?

Not on its own ledger. Every bitcoin is issued by the protocol on a fixed schedule, up to a limit of 21 million, and every full node checks every block against that schedule. No one, bank or otherwise, can create a bitcoin by making a loan.

How many bitcoins are there? The live count →

Claims on bitcoin are another matter. A balance at an exchange or custodian is a promise, like a bank deposit, and the firm can lend out or lose the coins behind it. FTX told customers that their assets, bitcoin included, were held in “custody” and kept separate from its own. In August 2024 a US federal court ordered FTX and its sister firm Alameda Research to pay $12.7 billion, $8.7 billion of it as restitution to customers and other victims, noting that “customer funds were commingled and misappropriated”.

The protection is to hold the keys yourself. Bitcoin in your own wallet is a full reserve by definition, because there is no promise in between. For savings, the arrangement The Bitcoin Transition recommends is a multi-signature wallet: several keys, generated on devices from unrelated makers and kept in different places, with more than one needed to move the coins. It asks more of you than a single key. Without a copy of the wallet's configuration, even all the keys may not recover the coins, so keep one with each key and practise with a small amount first.

A bank on a bitcoin standard could still lend out more than it holds. What it could not do is ask a central bank to create more bitcoin when its depositors come for their money.

Why self-custody is not optional →

Questions people ask

How do banks create money from a $1,000 deposit?

In the textbook model, with a 10% reserve ratio, the bank keeps $100 and lends $900; as the money is deposited and lent again, the $1,000 supports up to $10,000 of deposits. In reality, banks create a deposit whenever they make a loan, and do not need the $1,000 first.

What are the pros and cons of fractional reserve banking?

For: banks can offer instant-access accounts and long-term loans at the same time, and credit can grow with the economy. Against: banks are exposed to runs, the money supply swells and shrinks with credit, and the system leans on public backstops (deposit insurance and central bank lending) that shift risk onto other banks and the public.

What is the $10,000 bank rule?

It has nothing to do with reserves. US banks must report every cash transaction of more than $10,000, whether a deposit, a withdrawal or an exchange, to the Financial Crimes Enforcement Network (FinCEN) within 15 days (the regulation).

What is M0, M1, M2, M3, M4 money?

They are measures of the money supply, from narrowest to broadest. M0, or the monetary base, is notes and coins plus banks' reserves at the central bank. M1 adds deposits people can spend or move straight away, and M2 adds small time deposits and retail money market funds (Federal Reserve). The Fed stopped publishing M3 in 2006, and the Bank of England's broad measure is M4 (Bank of England).

Money 101: the reading list →

Sources

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The Bitcoin Transition

The Bitcoin Transition is a free, non-commercial educational project. We publish from first principles, in the voice of the protocol itself: direct, technically precise, and free from fiat-denominated framing.