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Fractional Reserve Banking
A fractional reserve bank keeps only a small fraction of it’s deposits as cash in the vault. It takes most of the money depositors have deposited and loans the money out to other customers.
The system works because on any given day, customers only want to withdraw a small fraction of the total deposits they have made. As long as the bank has just enough cash on-hand (reserves) to pay these withdrawals, it can use the rest of the deposited money to make loans.
So, suppose a bank had a total of $1,000,000 in deposits. The bank might only keep $200 thousand on-hand as cash reserves and will have already loaned-out $800 thouand to borrowers. On a typical day, the bank will need to pay out somewhere between $20-50 thousand in withdrawals and and it will take in another $20-50 thousand in new deposits. As long as each day’s net withdrawals (withdrawals – new deposits) are less than the cash reserves on-hand, the bank is solvent. Meanwhile, it can charge interest to the borrowers and earn profits that way.