Fractional-Reserve Banking

Banks know that not all customers will withdraw their deposits at the same time. So instead of holding all deposits as cash, they keep a fraction as reserves and use the remainder to make loans. This allows banks to earn interest and provide credit to households and businesses.

For example, if a bank receives a deposit of 1,000 and keeps 10% in reserve, it can lend out 900. That 900 may be spent and deposited in another bank, which in turn lends out a portion. Through this process, lending by the banking system as a whole creates new money, expanding the money supply.

Fractional-reserve banking makes credit widely available and supports economic growth. But it also creates a risk: if too many customers try to withdraw their money at once, a bank may not have enough cash on hand, leading to a bank run.

To reduce this risk, banks are regulated. They must hold capital and liquid assets, deposits are protected by deposit insurance schemes up to a limit, and central banks act as lenders of last resort in a crisis.