FIN310 • Fractional Reserve Banking — Step-by-Step, History & Game

Video — Fractional Reserve Banking: 10% Model, Zero U.S. Requirement & Bank Safety

Follow a hypothetical 10% reserve model, then connect it to modern U.S. banking: loan-created deposits, liquidity coverage (LCR), capital relative to risk-weighted assets, interest on Fed reserve balances, Treasury bills and bonds, and gold’s regulatory treatment.

Watch on YouTube ↗ 12 minutes 20 seconds • Blackboard examples and Liam narration

The 10% ratio is a teaching assumption. U.S. reserve requirements became zero in March 2020; lending still faces capital, liquidity, funding, and risk constraints. Gold is not Tier 1 bank capital or Basel Level 1 HQLA. Financial markets are complicated because these constraints interact—start with the balance sheet and the risk each rule addresses.

Video — Why Banks Fail

Watch on YouTube ↗

Key Takeaway — How Money Is Created & Why M1 ≠ MB

Loans create deposits. Deposits count in M1, so M1 can be many times larger than MB (currency + reserves). Each round banks keep a fraction as reserves and lend the rest → redeposit → repeat (a multiplier builds deposits).

Limits: required + excess reserves, currency drain (people hold cash), and capital constraints (equity/assets).

Reality today (useful facts for FIN310):

U.S.: formal reserve requirement is 0% since March 2020. Banks still hold reserves by choice for payments/liquidity and because reserves may earn interest.
Euro area: minimum reserve is about 1% of certain liabilities (cut from 2% in 2012). We use 20% only as a classroom example to show a small toy multiplier (≈5×) before leakages/capital.

FAQ (plain words)

Why is money supply bigger than what’s injected? Because commercial banks create deposits when they lend. Base money is the seed; lending multiplies deposits until frictions stop it.
What “fractional reserve” do banks actually use? There isn’t one number today. Formal minima (U.S. 0%, euro ≈1%) often don’t bind; liquidity and capital rules + risk appetite and loan demand do.
Why hold excess reserves? Payments safety, liquidity metrics (LCR/NSFR intuition), interest on reserves (if paid), collateral/ops, and conservatism.

History of Reserve Requirements

Pre-2020 U.S.: tiered rr; top tier 10% on large transaction deposits — the number many remember.
March 2020 U.S.: rr set to 0% across the board. Banks still hold reserves voluntarily; regime operates with ample reserves.
Euro area: rr ≈ 1% (cut from 2% in 2012).

Why this matters

If rr=0, what’s “fractional” now? Lending is mainly constrained by capital ratios and liquidity rules, not a fixed rr. The game below lets you flip between the old 10% rule and modern 0% to see the difference instantly.

0% Reserve Requirements: Why Banks Can’t Create Unlimited Money | FIN310

Why doesn’t a zero required reserve ratio mean unlimited deposit creation? Follow simple capital and liquidity examples, real Federal Reserve monetary-base and M1 figures, and the effects of stablecoins on bank funding.

Watch on YouTube ↗ 6 minutes 50 seconds • Liam narration • Captions and blackboard examples

Covers the 10% teaching model, the March 2020 U.S. reserve-rule change, M1’s May 2020 definition change, capital ratios, LCR and NSFR, insured-deposit protection, and stablecoin funding shifts.

Capital & Liquidity Rules — Plain English (with fractional rr)

Why this matters: Even if the required reserve ratio (rr) is low or 0%, banks can’t lend without limit. Two other sets of rules bite: capital ratios (can you absorb losses?) and liquidity rules (can you meet cash outflows?).

1) Capital ratios (loss-absorbing capacity)

CET1 ratio (core capital): Common equity / Risk-weighted assets. If this falls too low (minimum + buffers), the bank must slow/stop balance-sheet growth (new loans) or raise equity.
Leverage ratio (backstop): Equity / Total assets (no risk weights). Prevents too much leverage even if assets look “low-risk.”
In our game: Capital Min % is a toy version of these rules. We compute capital% = Equity / Assets with Assets = Reserves + Loans. If capital% drops below your minimum, lending stops—even if rr is small.

2) Liquidity rules (can you pay people on time?)

LCR (Liquidity Coverage Ratio): hold enough High-Quality Liquid Assets (HQLA: reserves, Treasuries, etc.) to cover projected 30-day net cash outflows (target ≥100%).
NSFR (Net Stable Funding Ratio): ensure stable funding over a 1-year horizon: Available stable funding / Required stable funding ≥ 100%.
Link to fractional rr: Even when rr is 0% or small, banks still hold extra liquid assets (often reserves/Treasuries) to satisfy LCR/NSFR and to make payments smoothly. This is why we talk about excess reserves in modern systems.

How these interact with rr (simple)

Constraint	What it asks	What “counts”	When it stops lending
Reserve requirement (rr)	Keep a fraction of deposits as reserves	Central-bank reserves, vault cash	When you don’t have enough reserves vs. deposits
Capital ratios	Keep enough equity vs. assets (loss buffer)	Common equity, retained earnings	When Equity / Assets (or risk-weighted) would fall below minimum
Liquidity rules (LCR/NSFR)	Hold liquid assets & stable funding	HQLA (reserves, Treasuries); stable funding	When adding loans would leave too little HQLA or stable funding

Where this shows up in the game

Capital Min % → toy capital constraint. As loans + reserves (assets) grow while equity stays fixed, the ratio falls and can bind.
Currency Drain % → mimics cash leaving banks (outflows), which makes redeposits smaller—think of it as a simple liquidity friction that shrinks the multiplier.
If you want to mimic liquidity buffers, choose a higher rr to represent banks voluntarily holding more liquid assets than required (excess reserves).

Intro

Fractional reserve banking lets banks create deposit money on top of the monetary base. The process stops when reserves, cash leakages, or capital requirements bind.

Engine vs Brakes — Modern View

Engine: Fractional reserve is still a great mental model for how loans create deposits. A new loan credits a deposit; deposits keep cycling until leakages, reserves, or capital stop it.

Brakes today: Even with rr = 0%, growth slows because of:

Capital ratios: CET1 & leverage rules force banks to hold enough equity vs. assets. If Equity/Assets is too low, lending stops.
Liquidity rules: LCR & NSFR require banks to hold HQLA and stable funding; too many loans without funding breaks the rule.
Behavior: risk appetite, loan demand, supervisory guidance, and profit motives all shape lending.

Key takeaway for FIN310: Fractional reserve banking is not useless — it explains the money creation engine. But the binding brake is usually capital/liquidity today, not a fixed rr. Use the game to see which brake engages first.

Step-by-Step Story

Deposit $1,000 → bank must keep rr% as reserves.
Bank lends the rest → borrower spends → seller deposits → next bank repeats.
With no leakages/constraints, total deposits approach initial/rr; loans ≈ initial(1−rr)/rr.

Link to M1 vs MB

Each round’s deposits add to M1; the reserves slice sits in MB. Higher reserves/leakage or tighter capital ⇒ smaller gap between M1 and MB.

Video — Fractional Reserve Banking & the Money Multiplier (Made Simple)

A clear walk-through of how loans create deposits and why the “multiplier” rises or falls with reserves, leakages, and constraints.

Source: YouTube — “Fractional Reserve Banking and the Money Multiplier Made Simple”

How to Play the Money Multiplier Game | Deposits, Reserves & Cash Drain | FIN310

Watch this five-minute guide before you play. Follow four clear steps: choose your settings, make an optional prediction, run the lending rounds, and read the results.

Watch on YouTube ↗ 5 minutes • Liam narration • Captions and 10 chapters

Start with a $1,000 deposit, then compare reserves only, 5% currency drain, and a capital limit. Learn why deposits grow, what slows the process, and why ten rounds differ from the unlimited-round multiplier. This is a simplified classroom model.

LEARN BY CHANGING ONE THING

Build the money multiplier

Start with $1,000. Keep some as reserves, lend the rest, and watch the loan return as a new deposit.

Hover over a field or focus its ⓘ button to see the definition. Tap ⓘ to keep the explanation open.

1 Choose your example

Try the first example, then change one setting to compare what happens. Choosing an example starts a fresh run.

Start here: run one round. $1,000 → keep $100 → lend $900 → redeposit $900.

Money, reserves, and cash

Initial deposit

Starting money

Enter 1000 to start with $1,000.

Required reserve

% of each deposit

Enter 10: keep $100 of a $1,000 deposit before any extra buffer.

Extra reserve buffer

% of each deposit

Enter 5 with required reserve 10: keep 15%, or $150 of $1,000.

Currency drain

% of each new loan

Enter 5: from a $900 loan, $45 stays as cash and $855 is redeposited.

More settings: capital limit and run length

Minimum capital ratio

% • 0 turns this limit off

Enter 6: $100 equity ÷ $2,000 assets = 5%, so the toy stops.

Equity for capital check

$ • fixed in this toy

Enter 100: $100 equity ÷ $1,000 assets = 10%.

Number of rounds

Whole number • 1–50

Enter 10 to observe ten lending rounds.

Total reserve rate

Calculated automatically

Required 10 + extra 5 gives a total reserve rate of 15%.

Teaching model: capital uses fixed equity ÷ (reserves + loans). Equity funding is not modeled separately, and this is not a regulatory capital calculation.

2 Make a prediction optional

Guess the total deposits after your chosen number of rounds. You can leave both boxes blank.

Predicted total deposits ($)

For the starting example, 10 rounds produce about $6,861.89, including the initial deposit.

Predicted lending rounds

Enter 10 if you expect all ten rounds to finish.

Show the mathematical hint

Each round passes on q = (1 − total reserve rate) × (1 − currency drain). Without a capital stop, total deposits through n rounds = initial deposit × (1 + q + … + qⁿ). The unlimited-round limit is initial deposit ÷ (1 − q), when q < 1.

3 Run and watch

Use Next round first. Then play the remaining rounds. Editing a setting resets the run.

4 Read your results

Total depositsInitial deposit + all redeposits

Total loansAll loans issued so far

Toy capital ratioFixed equity ÷ current assets

See the round-by-round numbers

Round 0 is the starting point. “New deposit” is the amount passed to the next round. Scroll the table sideways on a small screen.

Deposits, loans, cash, and reserves in dollars. Hover, focus, or tap a heading for its definition and calculation. Examples use 10% reserves, 5% cash drain, and $100 fixed equity. Calculations use full precision; displayed dollars are rounded.

Read the explanation for every round

What this simplified game assumes

Each new deposit keeps the same reserve fraction. The rest is lent; some of that loan stays as cash, and the rest is redeposited. Loans are not repaid during the activity. Current reserves equal reserves kept in earlier rounds plus the latest redeposit waiting to be lent. Capital is checked after each completed round, so a round can cross the threshold. This is a classroom illustration, not a forecast of a real bank.

Ask Maggie AI

Ask a question about deposits, reserves, the game, bank profits, or risk controls.

Type your question above, then select Ask Maggie.

Check Your Understanding — 10 True/False Questions

Read each complete statement, then choose True or False. Hover over an underlined term for its definition, or tap the ⓘ button. Five statements are true and five are false.

Review the key terms before you start

required reserve ratio (rr): The fraction of eligible deposits a reserve rule requires a bank to hold as reserves. In the U.S., these required ratios became zero effective March 26, 2020. A 10% ratio in this lesson is a hypothetical teaching assumption.
capital: The bank’s eligible loss-absorbing funding. Accounting equity is assets minus liabilities; regulatory capital applies eligibility rules and adjustments. Capital is different from cash available for payments.
equity: Owners’ residual interest: assets minus liabilities. Equity can absorb losses; it is not necessarily a separate pile of cash.
liquidity: The ability to meet payments and withdrawals when they are due, using available cash, settlement balances, liquid assets, or reliable funding.
Common Equity Tier 1 (CET1) capital ratio: Eligible core common-equity capital divided by risk-weighted assets. It measures a bank’s core loss-absorbing capital relative to the regulatory risk of its exposures.
risk-weighted assets (RWA): A regulatory exposure measure that applies risk weights to assets and certain off-balance-sheet exposures. It is different from unweighted total assets.
regulatory leverage ratio: Tier 1 capital divided by the applicable average-assets or exposure measure. This provides a backstop to risk-weighted rules. The game’s Equity / Assets ratio is only a simplified illustration.
Liquidity Coverage Ratio (LCR): Eligible high-quality liquid assets divided by projected net cash outflows over a 30-day stress period. The full standard normally requires at least 100%; U.S. scope and requirements are tailored.
Net Stable Funding Ratio (NSFR): Available stable funding divided by required stable funding over a one-year horizon. The full standard requires at least 100%, with tailored U.S. application.
high-quality liquid assets (HQLA): Assets that meet regulatory liquidity eligibility and operational conditions. Cash, central-bank reserves, and eligible Treasury securities can support the liquidity buffer. Treasury securities are not reserve balances.
Level 1 high-quality liquid assets: The highest category of assets eligible for the LCR liquidity buffer, including eligible cash, central-bank reserves, and certain sovereign securities. “Level 1” liquidity assets are different from “Tier 1” regulatory capital.
currency drain (cash leakage): In the game, the share of each new loan that becomes cash held outside banks and does not redeposit in the next round. This reduces deposit expansion; the cash itself is still money.
deposit multiplier: The model’s total deposits relative to the initial deposit. The simple 1 / rr formula needs explicit assumptions: full redepositing, no extra reserves, no cash leakage, no other binding constraints, and indefinitely many rounds.

Quiz — Why Banks Fail

10 true/false questions on bank runs, loan losses, bond losses, capital, and liquidity. Get instant feedback and explanations, and try again anytime.

Take the quiz — Why Banks Fail

Homework — Fractional Reserve (Easy Write-Up)

No calculator needed. Imagine explaining to a friend how money is created today.

Explain the engine: “Loans create deposits.” Use one short example (e.g., $1000 deposit → bank lends part).
Explain the brakes: Pick one brake (capital ratio, rr, or liquidity) and say how it stops lending.
Pick a risk: e.g. “If everyone withdraws cash at once, bank may run out of reserves.”

Write about 200-250 words — just enough for a clear paragraph.

Conclusion

Takeaway: Loans create deposits, so money supply can grow far beyond base money. Historically the U.S. often used a top-tier 10% rr; today rr=0% (Euro ≈1%), so capital/liquidity and behavior are the main brakes. The 20% example is just a teaching tool to show a small multiplier (≈5×) clearly.