Fractional Reserve

Lending has been historically limited by a fractional reserve ratio (FRR). A bank could only lend a proportion of its deposits, however as money is lent is is re-deposited and a proportion of this can be lent out. This new money that has been lent out gets spent buying, say a car, and then paid into a different account. A proportion of this new deposit is then lent out and so on. The initial deposit can be cash or electronic money - it doesn't matter.

The maximum amount of lending under FRR can be expressed as the initial deposit divided by FRR, i.e. A bank with an initial deposit to £1000 and a FRR of 3% could potentially lend £33,333 if all the money lent out was redeposited at the same bank. With 97% of money in the UK being electronic having been lent out initially against the 3% cash, it is reasonable to deduce that across the banking system a reserve of around 3.1% (3/97).

Because of the size and number of banks, they can be thought of a single whole when considering the effect of FRR, i.e. although money lent may not be paid into the same bank, it will be paid in to a bank somewhere and therefore allow that bank to lend a proportion. FRR is the key limiting factor to the lending of money and therefore the creation of money by banks.

The amount of credit that can be loaned from an initial deposit = deposit x 1/FRR, e.g £400 from a £100 deposit at 25% FRR.

Cycle Deposit Lent Reserve Cum. Lent Cum. Deposits
1 100.00 75.00 25.00 75.00 100.00
2 75.00 56.25 18.75 131.75 175.00
3 56.25 42.19 14.06 173.44 231.25
4 42.19 31.64 10.55 205.08 273.44
5 31.64 23.73 7.91 228.81 305.08
6 23.73 17.80 5.93 246.61 328.81
7 17.80 13.35 4.45 259.95 346.61
8 13.35 10.01 3.34 269.97 359.95
9 10.01 7.51 2.50 277.47 369.97
10 7.51 5.63 1.88 283.11 377.47

and so on until deposit = £400.00 and £300 has been lent out. There is a £100 debit to the banks cash account for the original deposit now sitting in the vault (or a corresponding £100 debit to someones account if the original deposit was a cheque).

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