This is one of the key principles underpinning the entire banking system. That’s because it’s the basis of ‘credit creation’.
Imagine I walk into a bank with £100 and deposit it. The bank sets aside 10%, or £10, in case I need that back. It reckons I won’t ever ask for more than that, so it then lends out the rest – £90. Let’s then say the borrower spends the £90, and the person he gave it to puts it back in the bank. The bank then keeps 10% back, or £9, and lends the remaining £81.
This process can continue. The bank is using a single deposit of £100 to create a lot more credit. It works, provided all of its depositors do not simultaneously march into the bank and demand all of their money back – an unlikely event in practice. The lower the retention rate – here, 10% – the more credit the £100 generates.
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