From the fractional reserve wikipedia article, a nice little example of this "fractional reserve" lending (excerpt, more at link).
http://en.wikipedia.org/wiki/Fractional-reserve_banking
Table Sources:
| Individual Bank |
Amount Deposited |
Lent Out |
Reserves |
| A |
100 |
80 |
20 |
| B |
80 |
64 |
16 |
| C |
64 |
51.20 |
12.80 |
| D |
51.20 |
40.96 |
10.24 |
| E |
40.96 |
32.77 |
8.19 |
| F |
32.77 |
26.21 |
6.55 |
| G |
26.21 |
20.97 |
5.24 |
| H |
20.97 |
16.78 |
4.19 |
| I |
16.78 |
13.42 |
3.36 |
| J |
13.42 |
10.74 |
2.68 |
| K |
10.74 |
0.0 |
10.74 |
|
|
|
|
|
|
|
Total Amount of Deposits: |
Total Amount Lent Out: |
Total Reserves: |
|
|
457.05 |
357.05 |
100 |
If you look at the Green cells, those are the actual Dollars, as in the first $100 that was initially deposited.
Therefore, what you have in this cycle of depositing and lending where you see Total Amount of Deposits, are bank account balances that are in customers' bank accounts.
So, if you ask how much "money" or "cash" is "in the economy" by asking the banks to tell you the total of customer deposits, you get that $457.05 amount. But that amount is "ON ACCOUNT", meaning the banks have that much liability to their deposit customers. That original $100 bill that was deposited - no new dollar bills were created in this process.
The initial $100 bill was simply put in the teller's drawer and added to the bank's pile of cash on hand. The accounting entry would be: owe customer $100 (credit), cash on hand $100 (debit).
Obviously if you subtract the Total Amount Lent Out from the Total Amount of Deposits, you get back to the original amount of cash money that was deposited, which equals, "magically", the Total Reserves. The individual banks ALL HAVE A PIECE OF THAT $100 AS THEIR RESERVES.
This is why it's very confusing, because we toss around terminology like "creating money" and "charging interest on money created", which are not an accurate depiction of what's going on and also not easily understandable.
Banks earn interest on the loans. Customers may earn a much smaller amount of interest on their balance - "on account". The difference is the "spread" the bank profits by, in effect, "borrowing" from the customer (the customer demand deposit account is a liability to the bank) and lending that borrowed money out. The original capital the bank was started with thus forms a cushion of equity in case loans default. When this equity cushion gets to be less than zero - that's when a bank is insolvent (bankrupt) - its total liabilities are more than its total assets.
With the benefit of this simple example, we can see that we simply have allowed banks to lend customer deposits, which are then typically deposited back into a bank. The key to remember is that the bank that lends the desposits no longer has their deposit customers cash any more - just a fraction of it (in this case 20%).
Customer deposits are an Asset on the customers books - Cash. To them, this is counted as if it were paper dollar bills in their hand, like a stack of $100s. But guess what - it's only "on account" at the bank, the bank does not keep all that cash even though the account is a "demand deposit" account, that is, upon demand of the customer, the bank must pay out the cash that they have on account for the customer in their bank account.
Thus we see that customer deposits are a Liability to the Bank. While the "lent out" monies - to the bank are Assets !
Of course the system is based on the bank not having every customer with a demand deposit account (like a checking account) all asking for all their money on the same day).
Banks can also Borrow... from other banks, etc. Those are also Liabilities to the bank. But such borrowings would be repaid on a schedule, not whenever the lender wants their money. CD's (certificates of deposit) are sort of a hybrid: the customer can get their cash back before the CD matures - but they must pay a heavy penalty, so the bank would not have to pay back the full amount according to the terms of the CD.
Banks thus have to manage their cash position, matching their need to pay out cash with the timing of assets they have that yield cash, either in period payments (like interest on bonds, etc.) or when investment instruments (like bonds, etc.) mature and the principle is returned.
"Full reserve" banking is an alternative to fractional reserve that gets discussed here and there. It's where all the cash for customer deposits must be retained by the bank. This would mean either paper dollars, or in the bank's account at the Fed (so if a bank needed paper dollars they could just make a call and the Fed would truck over paper dollars and deduct the amount from their account at the Fed; in practical terms the paper dollars would typically come from nearby banks). Of course, there rarely would be any "run" on such banks, because they would have all the cash needed whenever they needed it, since they never lent it out or invested it; it just sits in their vault and/or gets transferred to and from the Fed.
If banks' businesses were seperately accounted for, as in different companies under a bank holding company, and the one that does customer deposits was not responsible for the liabilities of the other "sister" banking companies, then customers would always be assured of their deposits being available, and the FDIC would not be necessary. Of course, the customer deposit bank would have to charge fees or interest on those accounts to produce revenue, since they could not produce revenue by lending those amounts out. Those banks would, in effect, be a vault service with checking and debit card capability.
In this scenario as things stand today, as far as bank balance sheets, there would be much less money available to lend out, certainly at first. After a while, people and businesses would probably start operating with less cash in their checking (demand deposit) accounts, and they'd move cash not needed in the short term to time deposits like CDs or they'd invest in other short term investments so they could avoid the charges for having their money in the "full reserve" checking account.
The problem with lending out customer deposits as is done in the "fractional reserve" system is that customers are assuming "cash in the bank" is a near-zero risk place to have their money. Just remember all the old expressions about "money in the bank", etc. Of course there is certainly risk in banks lending out money or buying financial instruments or in some way trying to earn money using the customer deposits - which is why the FDIC was created.
The existence of the FDIC thus allows banks to lend out customer deposits and push the risk of bank insolvency to the FDIC. Of course, the FDIC is supposed to be it's own beast, and not "the government", which is all well and good, normally. But as we can see from the 2008 meltdown when Hank Paulson asked George Bush for $700 Billion (with a B) worth of backing to make sure Wall Street was "ok", we see that ultimately if there is some "catastrophe", the financial burden of the catastrophe in practical terms is shifted to the government, which is really a euphemism for the taxpayer in cases such as this.