http://neweconomicperspectives.blogspot.com/2009/06/dont-fear-rise-in-feds-reserve-balances.html

Here’s how it would work today: let’s say California were to earmark $10 billion of its $62 billion socked away in investments as the capital for starting its new state-owned bank. It also takes in $10 billion of deposits (initially by transferring its own revenues out of the Wall Street banks where they are now). It can now, technically, make $18 billion in loans, keeping $2 billion in “reserve.” The $18 billion are added to both sides of the balance sheet, as assets and liabilities. It can now lend 90% of that, etc. That’s how it’s done technically, but in fact nobody checks to see if the reserves are there before making loans. The banks make loans to any creditworthy borrower who walks in the door. They only check the reserves and capital when the regulator comes around every three months, and if they don’t have them they either borrow from the money market or the Fed, or they sell off some loans temporarily until the heat is off. Meanwhile, interest keeps accumulating and adds to the capital base. So when the Bank for International Settlements comes knocking and wants to check the 8% capital requirement, they’ve got that covered too. They can extent their initial $10 billion to AT LEAST $100 billion in loans. And their initial $10 billion in investment is never at risk, unless they go bankrupt. That money is never “lent” and neither are the deposits of their customers. The worst that can happen is that some loans default and the bank no longer has as much in the way of “assets” (mainly meaning performing loans) as “liabilities” (checkbook money issued). The bank is then called a “zombie bank” — it can’t lend any more till it rebuilds its asset base — or it is declared insolvent and is put through bankruptcy. But a state bank would not go bankrupt, particularly if it were set up as a dba of the state (as the Bank of North Dakota is), unless the state itself went bankrupt; and a state has the power to tax, so that is highly unlikely, particularly if it can refinance all its old loans at very low interest rates.

Oh , this website creates a lot of misunderstanding .
The New York Federal Reserve gives a rather more sophisticated explanation.
http://www.newyorkfed.org/aboutthefed/fedpoint/fed45.html

But it is all made very clear on Page 57 of Fed Today
http://www.federalreserveeducation.org/fed101/fedtoday/FedTodayAll.pdf

The theory that banks can create “money out of nothing” comes in two forms.
In the crude version, it is argued that if the banks have to keep 10 percent of their assets as cash (as used to be the rule; it’s now as low as 1 percent) this means that if someone deposits $1000 in a bank that bank can then lend out $9000. Actually, what it means is that it can lend out $900.

The more sophisticated version takes over from here and assumes that the $900 is then spent and that the people who receive it then deposit it in one or other bank. These banks can then lend out 90 percent of what has been deposited with them, or between them a further $810. So that means that the original $$1000 has already become $1710. In other words, the banking system this has “created” an extra $710 “out of nothing”. But the process doesn’t stop here. The $810 also ends up with the banks, who then lend out a further $729. The process continues until, in the end, the banking system has lend out a total of $9000.

Banks can’t and don’t “create credit”. They can only lend out what has been lent to them, ie other people’s purchasing power. So, bank credit only re-arranges, not increases purchasing power.Banks are financial intermediaries that borrow money from some people and then lend it others. Banks fund loans to customers by a mixture of two methods, one of these is using money deposited with it from customers , the other is through the wholesale banking market, i.e. effectively money deposited with it from other institutions .Generally, small banks are deposit-rich and large banks are deposit-poor. Large banks loan out more money than has been deposited with them by borrowing from small banks. Small banks themselves borrow from depositors and other banks as well. An entire national economy can loan out more money than has been deposited in its banks by borrowing from foreign banks. The origin of their profits is the difference between the rate of interest they charge those they lend to compared to that they have to pay those the borrow from. An alternative to saying banks ‘create’ money is just to say that they help circulate it. The only body which can create additional purchasing power is the government via its Central Bank. It can in effect print more money.

Banks are not the only actors involved in the process – a bank makes a loan but that is not immediately redeposited, it gets spent on consumer goods or turned into productive capital so all these things have to happen first before it ‘comes back’ into the banking system, so the bank is not necessarily the active subject in all of this, so it’s not just like the banks sitting in isolation of everything deciding to create money out of nothing, if all the other activity didn’t happen then the banks wouldn’t be able to do what they do. It’s ‘created’ as a result of activities going on outside and outwith of the banks themselves, it’s not about them ‘creating’ credit and at some point it then having to react with the real economy, it’s about the activities of the real economy dictating it’s need and the banks responding to it.The fact that the bank doesn’t create money becomes obvious during a commercial crisis, during which too many depositors try to redeem their IOUs (their deposits) than can be redeemed- a run on the bank .

The present banking crisis is not all that complicated . When borrowing became less available and more expensive banks came unstuck. They found that, when their loans came up for renewal they had to pay more interest on them than they were getting from those they were lending money too. Since banks make a profit by paying depositors and creditors a lower rate of interest than they charge those they lent money to, this meant they were making a loss. That’s what can go wrong when banks can’t get hold of other people’s money on the right terms.
What can also go wrong is that they make unsound loans- the sub-prime situation . If they buy a house and the lend someone the money to buy it, if that person defaults they are left with the house. In normal times they can resell it but because there has been overproduction in the housing market they are finding that they can’t get the same price for it as they paid for it. In other words, they lost money.
In fact this effective overproduction in the housing sector could be said to be what has provoked the present financial crisis.

Another explanation of how banks cannot create credit can be read here http://www.marxists.org/archive/hardcastle/creatingcredit.htm

“Credit creationists…. are the ‘mystical school of banking theorists’”