Fractional reserves and how banks create money

The phrase “fractional reserve banking” suggests a simple picture. Savers deposit cash, the bank keeps a fraction in reserve, and it lends out the rest. That picture is still common in textbooks and in some licence business plans.

Central banks have described the process differently for more than a decade. Understanding the modern description matters for anyone designing a bank, because it explains which constraints actually bind: capital, liquidity and funding, not a reserve ratio.

How lending creates deposits

The clearest official statement is the Bank of England’s 2014 article Money creation in the modern economy. It states: “Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.”

The mechanics are bookkeeping. The bank records a new asset, the loan, and a new liability, the deposit credited to the borrower.

No existing saver’s balance is reduced. The borrower then spends the deposit, and it moves to other accounts, often at other banks.

A simplified balance sheet shows the effect of a new loan of 100 to a business customer.

Step	Bank assets	Bank liabilities	Money held by the public
Before the loan	Existing assets	Existing deposits and capital	Unchanged
Loan is made	Loan to customer +100	Customer deposit +100	+100
Customer pays a supplier at another bank	Reserves at central bank -100	Customer deposit -100	Unchanged in total; the deposit now sits at the supplier’s bank
Loan is repaid later	Loan -100	Customer deposit -100	-100

The third row is the one that matters for a single bank. The money created by the loan remains in the system, but it leaves the lending bank together with a matching amount of its reserves.

The same article describes the reverse process. When a borrower repays a loan, the deposit used to repay it is extinguished, so money is destroyed. Banks also create money when they buy assets such as government bonds from non-banks, and reduce it when non-banks buy bank-issued long-term debt or equity.

Two misconceptions the Bank of England corrected

The article identifies two common errors:

1. Banks as pure intermediaries. “Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits.”
2. The money multiplier. “In normal times, the central bank does not fix the amount of money in circulation, nor is central bank money ‘multiplied up’ into more loans and deposits.”

It adds that reserves “can only be lent between banks, since consumers do not have access to reserves accounts” at the central bank. Customers hold deposits, which are claims on commercial banks. Banks hold reserves, which are claims on the central bank.

Where reserves fit

Reserves are balances that banks hold at the central bank. They settle payments between banks: when a customer pays someone at another bank, the paying bank transfers reserves to the receiving bank.

A single bank that lends aggressively will therefore lose deposits and reserves to other banks as borrowers spend. It must attract deposits or other funding to replace them, or hold enough liquid assets to cover the outflow. This is why liquidity and funding, not the size of the reserve balance at the start, shape how much one bank can lend.

For the system as a whole, the Bank of England states that “neither are reserves a binding constraint on lending, nor does the central bank fix the amount of reserves that are available”. In normal times, central banks set the price of reserves, the interest rate, and supply the quantity that banks demand at that rate.

Reserve requirements in practice

A reserve requirement obliges banks to hold a minimum balance at the central bank, calculated as a percentage of certain liabilities. The Bank of England observed that reserve requirements “are not an important aspect of monetary policy frameworks in most advanced economies today”. Requirements still exist in many countries, at very different levels.

Jurisdiction	Requirement	Source
United States	0% on all liabilities since 26 March 2020	Federal Reserve
Euro area	1% on overnight deposits and deposits, debt securities and money market paper up to two years, since 18 January 2012; 0% on longer maturities	ECB
United Kingdom	No formal reserve requirement	Bank of England
India	Cash reserve ratio of 3.00%, alongside a statutory liquidity ratio of 18.00%	Reserve Bank of India

The euro area figures show that a requirement can be low and unremunerated at the same time. The ECB shows a remuneration rate of 0% on minimum reserves for the current maintenance period. Where a requirement exists, it is a cost of doing business in that jurisdiction and a factor in funding plans, but it is rarely what limits a new bank’s growth.

What a reserve requirement means for a new bank

1. The bank needs access to a central bank account, directly or through another institution, to hold required reserves.
2. Reserve holdings are an operational liquidity line in the cash flow model.
3. Where reserves are unremunerated, they reduce net interest margin on the deposits that attract them.
4. Requirements and remuneration can change, so business plans should test alternative settings.

What actually limits lending

The Bank of England identifies three sets of constraints on money creation by banks.

1. Limits on the banks themselves

Banks must lend profitably in a competitive market. Each new loan carries credit risk, and the bank must price for expected losses and hold capital against unexpected ones. It must also manage the liquidity risk that arises when the newly created deposits leave for other banks.

On top of these commercial limits sits prudential regulation. The article states that regulatory policy constrains banks’ activities “in order to mitigate a build-up of risks that could pose a threat to the stability of the financial system”, including through requirements on capital and liquidity.

2. Behaviour of households and companies

People who receive new deposits may use them to repay existing loans, which destroys the money again. The stock of money depends on those choices as well as on banks’ lending decisions.

3. Monetary policy

The article calls monetary policy “the ultimate constraint on money creation”. By setting the interest rate on reserves, the central bank influences loan rates and the demand for credit.

Why capital, not reserves, is the binding constraint

Capital is the loss-absorbing funding provided by shareholders and certain subordinated investors. Every new loan increases risk-weighted assets, and every increase in risk-weighted assets requires more capital to keep regulatory ratios above minimums.

In the EU, Article 92 of the Capital Requirements Regulation requires institutions to maintain at all times a Common Equity Tier 1 ratio of 4.5%, a Tier 1 ratio of 6%, a total capital ratio of 8% and a leverage ratio of 3%. Buffers and supervisory add-ons sit above these minimums.

A simplified example shows the effect. Suppose a bank’s lending carries an average risk weight of 100% and the bank needs a total capital ratio of 12% once buffers and add-ons are included.

Each additional 100 units of such loans then needs 12 units of capital. A bank with 60 units of spare capital above its requirements can add roughly 500 units of such lending before it must raise more capital or retain more profit, whatever its reserve balance.

Liquidity rules add a second hard constraint. A bank must hold enough high-quality liquid assets to survive a 30-day stress and must fund long-term assets with stable funding. These requirements are explained in the article on liquidity and funding.

Implications for founders and investors

1. Plan growth around capital. The lending book a bank can build is limited by the capital it has and can raise, after start-up losses.
2. Plan funding around deposit stability. Created deposits leave the bank when borrowers spend them, so the bank needs a reliable funding base.
3. Treat reserve requirements as a cost line. They matter for margins and operations, not as the main limit on growth.
4. Expect supervisors to test the plan under stress. Regulators assess whether capital and liquidity hold up if growth, losses or deposit outflows differ from the base case.

The next article explains how regulatory capital is defined and measured under the Basel framework.