Imagine walking into a bank and depositing £1,000 into your savings account. You might assume that money sits in a vault, waiting for you. But in reality, it’s on the move. Loaned out to a local business, funding a mortgage, or even flowing into the wider economy. How is that possible?
This is called fractional reserve banking. It is the foundation of modern finance, and a system that quietly powers everything from homeownership to economic growth.
To understand how your simple deposit transforms into economic momentum, we need to unravel a web of interconnected terms that make this system function. Each one is a thread in the fabric of modern banking and essential for any aspiring financier to know.
1. Central Banks
Before a single loan is made or a deposit accepted, there’s one institution pulling the strings behind the curtain: the central bank. Whether it’s the Bank of England, the European Central Bank, or the U.S. Federal Reserve, these institutions act as the anchor of the financial system.
A central bank is a national authority that manages a country’s currency, controls interest rates, and regulates the amount of money circulating in the economy. But more than that, it sets the rules that commercial banks must follow to ensure the system stays stable and liquid.
Why does this matter for fractional reserve banking? Because the entire concept depends on confidence. Confidence that depositors won’t all demand their money back at once, and that banks won’t take on reckless levels of risk. Central banks enforce this confidence through tools like monetary policy, reserve requirements, and emergency lending facilities, all of which create a safety net that makes the fractional reserve model viable.
Without central banks, there would be no framework to balance risk-taking with systemic stability.
2. Liquidity Coverage Ratio (LCR)
The LCR is a rule that requires banks to hold enough high-quality liquid assets, like government bonds or central bank reserves, to survive 30 days of extreme financial stress. It’s like a bank’s emergency funds in case of a bank run.
This requirement isn’t optional. It was introduced as part of Basel III, a global regulatory framework designed to make banks more resilient after the 2008 financial crisis. (You can read more about that in our previous blog post on Basel III: The Rule Book That Keeps Banks in Check.)
So, how does this connect to fractional reserve banking? In a system where banks only hold a fraction of deposits in reserve, liquidity becomes everything. If too many people demand their money at once, banks need instant access to cash. The LCR ensures they can keep their promises, even when under pressure.
3. Stress Tests
A stress test is a simulation that challenges a bank with “what-if” scenarios:
- What if interest rates spike?
- What if the economy crashes?
- What if everyone withdraws their deposits tomorrow morning?
Banks run these models to see how their balance sheets, capital, and liquidity would hold up under pressure. Regulators then use the results to decide if the bank needs to raise more capital or reduce its risk exposure. These tests became especially important after the 2008 financial crisis revealed how fragile some of the biggest institutions really were.
In the context of fractional reserve banking, stress tests are vital. Banks lend out the majority of the money deposited with them. This works. Until it doesn’t. Stress tests are how we prepare for those moments when confidence fades, liquidity dries up, and the system is pushed to its limit.
4. Capital Adequacy Ratio (CAR)
Capital Adequacy Ratio (CAR) is the measure of whether a bank has enough capital to stay standing when things start to shake.
The Capital Adequacy Ratio is the percentage of a bank’s capital (its own money, not depositors’) compared to its risk-weighted assets. This included things like loans, mortgages, and investments that carry different levels of financial risk. The higher the CAR, the more protection the bank has against unexpected losses.
In simple terms, CAR is the cushion. When loans go bad or markets drop, it’s the capital that absorbs the blow. Regulators require banks to keep this ratio above a certain level to ensure they don’t crumble under financial pressure.
Why does this matter in a fractional reserve system? Because banks don’t keep most of your deposits in a vault, they lend it out. That lending creates growth, but also exposes the bank to risk. If too many borrowers default or the market takes a hit, the bank needs a safety buffer. CAR makes sure that the buffer is there.
5. Fractional Reserve Banking
Fractional reserve banking is the system that allows banks to take your deposit and lend most of it out. If you deposit £1,000, the bank might keep just £100 in reserve and use the other £900 to issue loans, invest, or support other parts of the economy. Banks don’t just store money, they create it.
Here’s how it works: when a bank lends out that £900, the borrower might spend it at a shop, which then deposits the money into another bank. That bank can now lend out 90% of that deposit. And so the cycle continues, multiplying money through the system. This is what fuels credit, investment, homeownership, and economic growth.
But there’s a catch, it only works if people don’t all demand their money back at once.
That’s why everything we’ve discussed, central banks, liquidity rules (LCR), stress tests, and capital adequacy, exists. Because fractional reserve banking is powerful, but fragile. It relies on a delicate balance between reserves and risk.
Take Aways
Understanding how central banks, liquidity rules, stress tests, and capital ratios work isn’t just for policy nerds or investment bankers. It’s the foundation for understanding how our entire financial system actually functions.
At the centre of it all? Fractional reserve banking, a system that quietly powers everything from mortgages to market stability.
Whether you’re a student just getting started, an aspiring analyst, or simply someone curious about how money really moves, these are the fundamentals worth knowing.
Because the more fluent you are in how the system works, the more confident you’ll be navigating it.
