A herd of people show up the day after the opening to put their gold (i.e. money) in the new banks. The bankers accept 200,000 M-oz. of gold as deposits in their new banks. They record a 200,000 M-oz. liability to show the amount of gold they owe to their depositors. We have come to call those liabilities “deposits;” they simply represent liability for those deposits.

With the addition of these deposits The Banks now own 300,000 M-oz. of gold.

Not a bad start for our Fantasy Banks.

Fractional Reserve Banking

The new Fantasy Banking System has adopted the practice of fractional reserve banking. This means that banks must keep available for withdrawal by depositors a quantity of a reserve asset (e.g. gold) equivalent to a fraction of their liability to depositors. The bankers of The Fantasy Banking System have set their reserve requirement at 40% of deposit liabilities.

This reserve requirement of 40% means that these banks must hold no less than 80,000 M-oz. in reserve assets to meet the 200,000 M-oz. in liabilities they now have to their depositors. Since they now have 300,000 M-oz. of gold (a reserve asset), it would not create a problem if all depositors showed up tomorrow asking for their gold. They would all get paid. But, this could change.

With 300,000 M-oz. in actual reserves and only 80,000 M-oz. required reserves, The Banks have 220,000 M-oz. in what bankers refer to as excess reserves (actual reserves less required reserves = excess reserves). (See the reserve requirement percentage and amount of excess reserves at top of The Banks charts.) Excess reserves play a critical role in the operation of The Banks and the money creation process.

The amount of excess reserves limits the amount of additional deposit liabilities the banks can create without adding to reserve assets. With 300,000 M-oz. reserve assets and a 40% reserve requirement, the 220,000 M-oz. in excess reserves permits them to create an additional 550,000 M-oz. in deposit liabilities without breeching the reserve requirement limit. (220,000 M-oz. in excess reserves divided by the 40% reserve ratio = limit of additional deposits)