fractional-reserve banking

Picture a goldsmith in old times who stores people's gold for safekeeping and gives each a paper receipt. He soon notices that on any given day only a few owners come to collect their gold; most receipts just circulate as money. So he quietly lends out some of the stored gold, confident he can still pay anyone who shows up. He is keeping only a fraction in reserve and lending the rest — and that, in essence, is fractional-reserve banking, the system every modern banking system runs on.

Concretely, a bank holds in reserve only a small fraction of the deposits it owes its customers, and lends out the remainder. If a bank holds 10% in reserve, then for every $1,000 deposited it keeps $100 ready and lends $900. This is safe most of the time because depositors don't all withdraw at once — withdrawals and new deposits roughly balance day to day. The system rests on a confidence trick that usually works: the bank promises every depositor their money on demand, yet it physically holds only a fraction of that money at any moment, because it has lent the rest to other people who are slowly paying it back.

Fractional reserves are the engine that lets banks create money and lets savings flow into investment, which is most of why an economy can grow. But the same design carries an inherent fragility: because the bank cannot instantly produce everyone's money, a wave of simultaneous withdrawals — a bank run — can topple even a solvent bank purely because it ran out of ready cash, not because its loans were bad. This is the central trade-off of the system, and it is exactly why central banks act as lenders of last resort and governments insure deposits: to keep the confidence that makes fractional reserves stable.