Fractional reserve banking
Fractional reserve banking is the system in which banks keep only part of their deposits as cash reserves and lend out the rest, which creates new money in the economy.
When a bank lends a deposit, the borrower spends it and it becomes someone else's deposit, which can be lent again. That chain is how commercial banks create most of the money supply.
The system works as long as depositors don't all ask for their money at once. When they do, it's a bank run.
Related terms
- Bank run: A bank run happens when many depositors withdraw their money at once because they fear the bank will fail, which can make it fail even if it was sound.
- Capital requirements: Capital requirements are rules that make banks fund part of their lending with their own money (equity) so they can absorb losses without failing.
- Money supply: The money supply is the total amount of money in an economy.
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