Money multiplier

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.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

See Tim Bennett's video tutorial: How banks create credit