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Have you ever wondered what happens to the "cash" sitting in your checking and savings account? What does the bank do with it? Where does it go? In order to answer these questions, you need a little bit of history.
Money was not always used as the medium of exchange for any asset. It evolved after years of barter transactions (meaning, a physical exchange of one good for another). The problems arrived when some goods were harder to value, not easily accessible, divisible, counterfeited, etc.
Gold and silver were used as commodities whose value barely defaulted, was easily accessible, valued, divisible and harder to counterfeit. This led to a crucial development in the history of money, the promissory note. It all began with individuals leaving their gold with goldsmiths to look after it for them. In return, the goldsmiths provided the depositors a receipt, stating how much gold they had deposited. The receipts traded directly for goods and services. Of course, the buyer and seller had to trust the goldsmith since he had all the gold, and the buyer and seller only had pieces of paper. Many of these early goldsmiths evolved into banks taking in other people’s gold and issuing depository receipts (promissory notes). It became clear to the goldsmiths and early banks that not all the gold that they held in their vaults would be withdrawn at any one time, and gold could, therefore, be lent to others at a rate of interest. By doing this, the early banks created money.
This practice of lending customers’ money to others on the assumption that not all customers will want all of their money back at any one time is known as fractional reserve banking.
Here is how it works:
1)The reserve requirement (money they need to retain) is only 10% of any money deposited.
2) When a customer deposits $100 in Bank A, this deposit changes the balance sheet of Bank A (Assets +$100, Liabilities +$100). It represents a liability to the bank since effectively it was loaned to the bank by the customer.
3) Bank A's balance sheet will have in the Assets side $90 loans + $10 in reserves (meeting the 10% reserve requirement).
4) Bank A will then lend 90% of this deposit ($90) to another customer. Notice that the balance sheet still balances; $100 worth of assets and $100 worth of liabilities.
5) Now suppose the loan of $90 (by Bank A) is given to a vendor who uses this money to purchase some goods and the seller of the goods deposits his $90 sale in another bank, the Bank B. Bank B proceeds with the same process; (Assets + $90, Liabilities +$90). It retains 10% and loans out 90% ($9 in reserve and loans $81).
6) The customer, in turn, spends $81 on some goods or services. The seller of these goods and services deposits it at Bank B, and so on. This shows how money is created when a bank makes a loan.
The process continues until there is no more money left to be deposited and loaned out. The total amount of money ‘created’ from this one deposit of $100 can be calculated as:
New deposit/Reserve requirement = $100/0.10 = $1,000
In some economies, the central bank sets the reserve requirement. A prudent bank would be wise to have sufficient reserves, such that, the withdrawal demands of their depositors can be met in stressful economic and credit market conditions.