A simple way to understand how banks create money is through a process called fractional reserve banking. The 'fraction' is the key part.
The Basic
Idea
When
a customer deposits money in a bank, the bank doesn't just lock it in a vault. It
is required to keep only a small fraction of your money on hand (this is the
"reserve"). It lends out the rest.
The
"magic" happens when the bank makes a loan. It doesn't hand over a
briefcase of cash. Instead, it simply adds digital numbers to the borrower's
bank account. In that instant, new money is created.
Let's walk
through it.
A Simple
Example: The $1,000 Deposit
Imagine
the "reserve requirement" is 10%. This means banks must keep 10% of
all deposits on hand and can lend out the other 90%.
- A customer deposits $1,000
into Bank A.
- Bank A's vault: It holds $100 (10% reserve)
and can lend out $900.
- Initial Money Supply: $1,000 (your deposit).
- Bank A
lends $900 to Sarah, who is buying a bike from Tom. The bank puts
that $900 loan into Sarah's account.
- Sarah buys the bike and pays $900
to Tom.
- Tom deposits that $900 into
his account at Bank B.
- Total Money Supply: Now it's $1,900 (your
$1,000 + Tom's new $900).
- Bank B's vault: It now has Tom's $900 deposit. It
holds **$90** (10% of $900) and can lend out **$810**.
- Bank B lends $810 to Martin,
who gets a new deposit for that amount.
- Total Money Supply: Now it's $2,710 (your
$1,000 + Tom's $900 + Martin's $810).
This
process continues, with each new loan creating a new deposit, which is then
re-deposited and re-loaned (in smaller and smaller amounts). The customer’s single
$1,000 deposit has allowed the banking system to "multiply" it
into thousands of dollars of new money.
Key
Takeaways
- Banks
create money by lending.
They don't lend your actual money; they create new digital money (a
deposit) for the borrower.
- This
new money is technically debt.
The borrower gets a deposit (an asset) but also has a loan (a liability).
- The
reserve requirement. Set
by the central bank, it controls how much money can be created. A lower
requirement means banks can lend more, creating more money.
- An
important note: In
some countries, like the United States, the reserve requirement has been
set to 0%. Banks are no longer limited by this rule, but other
regulations (like capital requirements) still govern how much they can
lend. However, the basic principle of creating money through new loans
remains the same.
The Money
Multiplier: How Banks "Gear Up" an Initial Deposit
The
number of times a bank can "multiply" an initial deposit is
determined by the Money Multiplier.
The formula
is simple:
Example: The
10x Multiplier. Let's
use the same 10% reserve requirement as an example.
- Reserve Requirement: 10% (or 0.10)
- Calculation: 1 / 0.10 = 10
This
"10" is the multiplier.
It means that for every $1 deposit, the banking system can eventually create a
total of $10 in the money supply. So, with the original $1,000 deposit, the
maximum amount the money supply can "gear up" to is $10,000 ($1,000 x
10).
Here is a
table showing how the "gearing up" happens:
|
Round |
New
Deposit |
Reserve
Held (10%) |
New
Loan Created (90%) |
Total
Money Supply |
|
Start |
$1,000.00 |
$100.00 |
$900.00 |
$1,000.00 |
|
2 |
$900.00 |
$90.00 |
$810.00 |
$1,900.00 |
|
3 |
$810.00 |
$81.00 |
$729.00 |
$2,710.00 |
|
4 |
$729.00 |
$72.90 |
$656.10 |
$3,439.00 |
|
... |
... |
... |
... |
... |
|
Final
Total |
**$10,000.00** |
$1,000.00 |
$9,000.00 |
$10,000.00 |
In Reality, the "Fractional Reserve Banking" terminology
In
reality, this "gearing up" (or multiplier) based on deposits is a simplified model
that is no longer accurate for modern banking. The "gearing"
is not limited by reserves. In fact, in many major economies, the reserve
requirement is now 0%.
The Plot Twist: The 0% Reserve Reality
In March 2020, the U.S. Federal Reserve (and many other central banks) officially reduced the reserve requirement ratio to zero. (In Malaysia, the Statutory Reserve Requirement (SRR) is 1.0%. This rate was set by Bank Negara Malaysia (BNM) and became effective on May 16, 2025, after being lowered from the previous rate of 2.0%. The SRR is the proportion of a banking institution's eligible liabilities that it must hold as a balance in its Statutory Reserve Account (SRA) with the central bank. BNM uses the SRR as an instrument to manage liquidity in the banking system.
Anyhow, if the old model were true, a 0% requirement would mean an infinite multiplier. Banks could create unlimited money. This is clearly not the case. This single fact proves that reserves are not what limit bank lending. This leads to the real story.
The Real Limit: Capital Requirements
(Basel III)
So, if banks
don't need reserves to lend, what stops them? The answer is Capital.
- Reserves (Old Model): A bank's liability. This is the depositors'
money that the bank holds.
- Capital
(Real Model): A
bank's asset. This is the bank's own money—from shareholders and
profits. This is its "skin in the game".
This is how
it really works:
- A bank does not wait for a deposit.
It finds a creditworthy borrower for a home loan.
- The bank creates the loan ex
nihilo (from nothing).
- It does
this by simply typing numbers into a customer's account. In that instant, new
money (a deposit) is created.
- The actual
limit on this creation is the Capital Requirement, set by
international rules like Basel III.
- Regulators might say, "For
every $100 you lend, you must have $8 of your own capital to absorb
the loss if that loan goes bad".
The
limit is no longer a reserve limit; it is capital. A bank with $8 million in
capital could "gear up" and create $100 million in loans, regardless
of its deposits.
The
Fundamental Conflict: Conventional vs. Islamic Banking
This
"money-from-nothing" model is the foundation of the conventional
banking system. And it is, by its very nature, in direct conflict with the
principles of Islamic finance—and the capital requirement rule doesn't solve it.
The conflict isn't about safety rules. It's about the very source and
purpose of money.
1. Riba
(Interest)
The
conventional bank creates a $100,000 debt from nothing. Its entire
business model is to charge a fixed, guaranteed fee (interest) on that created
debt. It is "renting" money for a guaranteed profit. This is the
definition of Riba (interest), which is strictly prohibited in Islam.
2. Creating
Debt vs. Financing Assets
The
conventional bank creates pure debt. The loan is just a digital number, a
claim, not tied to any real-world asset.
- A
Malaysian Example:
In Malaysia, for example, personal loans (via personal financing, credit
cards, etc.) can create unnecessary spending, placing many young people in
debt.
- Based on
recent data from Bank Negara Malaysia (BNM) and other financial
reports, the Malaysian banking system's lending is heavily weighted
towards households rather than the business sector. Lending to the
household sector makes up the majority of total bank lending in Malaysia,
at approximately 55-60%. The remaining 40-45% is directed towards
"real economy" sectors, such as businesses, trade,
manufacturing, and construction.
- What
is "Household Debt"?
This large 55-60% "household" portion is not primarily small
personal loans or credit card debt. The overwhelming majority are tied to
asset purchases:
- Mortgages (Home Loans): This is the single biggest
component.
- Vehicle Financing (Car Loans): The second-largest driver.
- Personal
Financing & Credit Cards:
This includes unsecured personal loans and outstanding balances.
- As of
recent data, household lending (driven by mortgages and car loans)
continues to grow at a faster pace than business loans.
While
Islamic finance, in principle, prohibits the creation of pure debt, a common
workaround in practice is the Tawarruq contract. This instrument,
often justified as a temporary solution based on public interest (maslahah),
faces significant criticism for being a 'disguised sale' that
synthetically creates debt. This reliance raises a persistent question: For how
long can such concessions be made before they undermine the foundational
principles of asset-backing and risk-sharing?
It
is important that all Islamic financing must be tied to a real, tangible asset
or service. An Islamic bank cannot just give you $100,000 in "debt". Instead
(in a Murabaha contract, for example), the bank must first buy the house
itself. It then sells that house to you at a pre-agreed-upon markup. Your
payment is for a real asset (the house), not for "money". The bank's
profit comes from a sale, not from lending.
3.
Risk-Transfer vs. Risk-Sharing
This is the
most critical difference.
- In the conventional
model, the bank transfers all risks. If you take a loan and your business
fails, you still owe the bank its money plus interest. The bank
has a guaranteed profit and takes zero risk in your actual venture.
- In the Islamic model, this is unjust. Financing must be based on Profit and Loss Sharing (PLS). In a partnership (Mudarabah), if the venture loses money (without negligence), the bank (as the capital provider) bears that financial loss. The bank must share the risk of making a profit.
|
Feature |
Conventional
Model |
True
Islamic Banking |
|
What is
Created? |
Debt (from nothing) |
A Sale or
Partnership (tied to a real asset) |
|
Source of
Profit? |
Interest
(Riba) (A fee for
lending money) |
Profit
(Ribh) (From
a sale or a share in a venture) |
|
Risk
Structure? |
Risk-Transfer (Borrower
takes 100% of the risk) |
Risk-Sharing (Bank and
customer share the risk) |
|
Capital
Requirement? |
Yes, a regulatory safety rule. |
Yes, a regulatory safety rule. |
Even with modern Basel III capital rules, the conventional system is still based on creating debt from nothing and charging interest on it. This violates the core Islamic principles of prohibiting Riba, requiring asset-backing, and demanding risk-sharing.
These videos on fractional reserve banking provide a simple visual walk-through of this money-multiplying process.
Encik Zahid menerangkan berkaitan "Money Creation"
dalam Bahasa Melayu. Click CC to auto translate to English etc
A Shocking History: The U.S. Bank Failures Where Customers Actually Lost Their Money
When a bank fails, we often hear about government bailouts and how depositors are "made whole." After the 2023 failure of Silicon Valley Bank, the government famously stepped in to cover all deposits, even those over the $250,000 FDIC insurance limit.
This leads to a common misconception: that customers never lose their money.
But history tells a different story. While the U.S. system is designed to protect depositors, it's not foolproof. There have been several painful moments where bank failures resulted in real, permanent losses for customers.
Let's look at the cases where the safety net tore.
1. The S&L Crisis: When Insurance Wasn't Enough (1980s)
The Savings & Loan (S&L) Crisis of the 1980s and 1990s was the largest-scale failure in modern U.S. banking history, with over 1,000 institutions collapsing. While the federal government ultimately staged a massive $132 billion taxpayer-funded bailout, many customers lost money in two distinct ways.
Case 1: The State-Fund Collapse (Ohio & Maryland, 1985)
The Banks: Home State Savings Bank (Ohio), Old Court Savings & Loan (Maryland), and 70+ others.
The Failure: These S&Ls weren't insured by the federal government (FSLIC, the precursor to FDIC). They were insured by private, state-run insurance funds. When a few large banks failed due to fraud, the state insurance funds were drained and became insolvent.
The Customer Losses:
In Ohio, the governor declared a "bank holiday," freezing all deposits at 70 institutions.
In Maryland, the governor was forced to limit depositor withdrawals to $1,000 per month to stop the panic.
Customers were locked out of their life savings for months, and in some cases, years. State-level bailouts eventually made most depositors whole, but not before they faced the reality that their primary insurance had completely failed.
Case 2: The Lincoln Savings & Loan Fraud (1989)
The Bank: Lincoln Savings and Loan (owned by Charles Keating).
The Failure: This was a case of pure deception. Bank employees were trained to sell high-risk "junk bonds" from its parent company, American Continental Corporation, to customers inside the bank branches.
The Customer Losses:
Over 21,000 customers, many of them elderly, bought $285 million in these worthless bonds believing they were safe, insured bank deposits.
When the parent company went bankrupt, the bonds became worthless. These customers lost everything.
While the bank's insured deposits were covered, the $3 billion federal bailout of Lincoln did nothing for the victims of the bond fraud.
2. IndyMac: The Modern Loss (2008)
This is the clearest modern example of uninsured depositors suffering direct, permanent losses.
The Bank: IndyMac Bank, F.S.B.
The Failure: At the height of the 2008 financial crisis, IndyMac collapsed under the weight of bad mortgages. The FDIC seized the bank.
The Customer Losses:
At the time, the FDIC insurance limit was $100,000.
IndyMac had roughly 10,000 depositors with funds over that limit, totalling about $1 billion in uninsured deposits.
The FDIC paid these depositors an "advance dividend" of 50 cents on the dollar for their uninsured funds. The other 50% was gone, permanently.
Total Customer Loss: Approximately $500 million.
The Government Cost: The bank's failure cost the FDIC's Deposit Insurance Fund (which is funded by other banks) an estimated $12.4 billion.
Why Most Bailouts Don't Lead to Customer Losses
It's important to contrast these stories with the "bailouts" we more commonly hear about. In most modern cases, the government's top priority is preventing customer panic and losses.
Year | Bank(s) | Government Action | Customer Losses |
| 2023 | Silicon Valley Bank (SVB) | The FDIC invoked a "systemic risk exception" to cover all deposits, even those over the $250,000 limit. | None. |
| 2008 | Washington Mutual (WaMu) | The FDIC seized the bank and immediately sold it to JPMorgan Chase. All depositors were fully protected. | None. |
| 2008 | The 2008 System (TARP) | The $700 billion "Troubled Asset Relief Program" was a $31.1 billion net cost to taxpayers to stabilise the entire system and prevent a domino collapse that would have wiped out everyone. | None. (This action prevented depositor losses). |
| 1984 | Continental Illinois | The government declared the bank "too big to fail" and issued a blanket guarantee covering all deposits, stopping a global bank run. | None. |
The 1998 Malaysian Bank Run: When MBf Finance Almost Collapsed
For most Malaysians today, bank runs are something we only read about happening in other countries. But in 1998, during the height of the Asian Financial Crisis, Malaysia faced its own terrifying banking panic—a classic bank run on what was then its largest finance company, MBf Finance Berhad.
This event is a critical part of our financial history, not because of a disaster, but because it showed how a crisis can be stopped.
What Triggered the Panic?
The year was 1998. The Asian Financial Crisis was tearing through the region. Currencies were collapsing, businesses were going bankrupt, and public confidence was at rock bottom
Amid this economic turmoil, rumours began to swirl that MBf Finance was in deep trouble, holding massive bad loans and facing insolvency.
For depositors, these rumours were a terrifying prospect. Fearing the bank would collapse and take their life savings with it, they did the only logical thing: they ran to get their money out.
The Bank Run
What happened next was a scene straight out of a history book.
Mass Withdrawals: Thousands of panicked depositors lined up at MBf branches all across the country.
A Classic Bank Run: The lines grew longer, and the panic fed on itself. News of the bank run only caused more people to join the queues, demanding their cash immediately.
The Liquidity Crisis: This is the critical weakness of any bank. MBf, like any bank, didn't keep all its deposits in a vault; the money was loaned out. It simply did not have enough cash on hand to pay all its depositors at once.
MBf Finance was on the brink of collapse, not necessarily because it was worthless, but because it was illiquid. It could not meet its commitments, and confidence was completely broken.
The Government Steps In
Before the bank could completely fail and trigger a catastrophic domino effect across the entire Malaysian banking system, Bank Negara Malaysia (BNM) stepped in with decisive and powerful action.
BNM Took Control: In 1999, the central bank officially took control of MBf Finance to manage the crisis.
The Blanket Guarantee: Most importantly, BNM issued a blanket guarantee for all deposits. They publicly assured every single depositor that the government would cover 100% of their money, including both principal and interest.
The Outcome: A Crisis Averted
The effect of the government's guarantee was immediate. The panic stopped.
Why? Because the run was driven by a fear of loss. Once the government—a "too-big-to-fail" entity—publicly guaranteed all deposits, that fear vanished. There was no longer any reason to line up and pull your money out.
In the end, not a single depositor at MBf Finance lost a single cent.
This event was a powerful lesson in financial stability. It demonstrated the critical role a central bank plays as a "lender of last resort" and a protector of public confidence. It was this crisis, and others from that era, that led to the creation of Perbadanan Insurans Deposit Malaysia (PIDM) in 2005, ensuring a formal, automatic insurance system is now in place for all Malaysians.
A Deeper Takeaway: The Bank Run and the Fractional-Reserve Problem
These historical failures highlight a fundamental vulnerability at the heart of our financial world: the fractional-reserve banking system.
The main critical weakness in this system is liquidity.
The bank's promise (its liability) to you is that your $1,000 deposit (for example) is "liquid"—you can withdraw it at any time. But its assets (the $900) are "illiquid"—they are locked up in a 30-year mortgage. This system works perfectly as long as everyone has confidence.
The "systemic withdrawal" you mentioned is what's known as a bank run. It's a crisis of confidence. It's not that the bank is worthless (it still has that $900 mortgage as an asset), but it is illiquid. It simply does not have the cash on hand to give all its depositors their money back at the same time.
When a bank run starts, the bank can't "fulfil its commitment." This is the moment a bank fails.
This is precisely why the U.S. government created the FDIC and has stepped in with "systemic risk" guarantees (like for SVB). These measures aren't just to protect money; they are to protect confidence and prevent the bank run that would expose the inherent instability of the fractional-reserve system.
Islamicbankingway
ONLY ALLAH KNOWS BEST
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