Fractional Reserve Banking
In the 1600s, people would pay goldsmiths to store their gold and other valuables safely. The goldsmiths would provide a note reflecting the value stored at the goldsmith, these notes were sometimes traded for other items of value. From these early beginnings, the concept of banks and paper money was born. In today's world, most modern nations use the concept of fractional reserves as part of their monetary policy.
The biggest hazard with fractional reserves is people's confidence in the monetary system and individual banks. The 1930s, in the U.S. saw many banks fold due to large numbers of customers seeking to withdraw their cash deposits. When too many people withdraw cash from a bank, the bank loses liquidity which can then start a snowball effect culminating in the bank's failure. These "bank runs" are now not as likely with the increased customer confidence brought about by government insured deposits. Interbank lending will also prevent momentary spot shortages of liquidity.
Banks in the United States will have different reserve requirements based on several factors, one being the overall amount of deposits controlled by that banking entity. For our discussion, let's say a bank has a 7% reserve requirement. If a customer walks in and deposits $100,000 the bank will need to keep $7,000 in cash reserves, but is free to utilize or lend the remaining $93,000 to other customers.
Creation of Money Using Fractional Reserve Banking
Staying with our concept of a bank with a 7% reserve requirement and a customer depositing $100,000.
The bank creates a liability to the customer for $100,000, effectively saying we owe you (depositor) $100,000.
The bank keeps $7,000 in liquid cash reserves.
The bank then lends out $93,000 at higher interest rates than are paid to the depositor.
$100,000 - Note from bank to depositor
$93,000 - Notes from one or more debtors to the bank
The system works fairly well for economic expansion as long as the bank has sufficient reserves to pay any single or multiple depositors seeking to withdraw large amounts of cash. Or unless a significant number of creditors cannot repay their loans. The recent Great Recession was an example of what happens when the debtors cannot or will not repay. Huge amounts of credit was extended to debtors in order to purchase over inflated assets and when that real estate bubble burst, the effects started rippling through the financial world. The daisy chain where lender lends to lender lends to lender makes the situation somewhat tenous.
Overview of Fractional Reserve Banking - Khan Academy
Fractional Reserve Banking - An Economist's Perspective - Federal Reserve Board - Atlanta