New on FinoLib · Volume I: Global Economy
My latest article is now live on FinoLib, the free finance library I write: Fractional Reserve Banking Explained: How Banks Create Money, from Volume I: Global Economy. Read the summary below for the substance of the topic, then continue to FinoLib for the complete treatment.
3.1 What Banks Actually Do
The idea in plain words
A bank takes deposits, makes loans and lives on the margin between the interest it earns and the interest it pays. It also runs payments and judges credit, and it funds long loans with deposits that can leave at any moment, which is useful and is also the source of bank runs.
Key points
■If a bank earns $7 a year on every $100 it lends and pays $2 on every $100 of deposits, the $5 difference, before loan losses and running costs, keeps it in business (illustrative rates).
■Maturity transformation, such as funding a 30-year mortgage with deposits customers can withdraw at any moment, is useful and is also the source of bank runs.
■When banks stopped lending in 2008, economic activity seized up almost immediately; making a loan creates a new deposit.
A closer look
At its simplest, a bank takes in deposits — money people and organizations leave with it for safekeeping, earning a small interest rate — and makes loans to borrowers who need money, charging them a higher interest rate. The difference between what the bank pays depositors and what it charges borrowers is called the spread; measured against all the assets the bank earns interest on, it is the net interest margin (NIM), and it is the core of how a bank makes money. If a bank earns $7 a year on every $100 it lends and pays $2 a year on every $100 of deposits, the $7 − $2 = $5 difference, before loan losses and running costs, is what keeps it in business (illustrative rates).
Recap
A bank takes deposits, makes loans and lives on the net interest margin between them, while also running payments, judging credit and performing maturity transformation: funding long loans with deposits that can leave at any moment. It does not need your deposit before it lends; making a loan creates the deposit.
3.2 How Banks Create Money — Fractional Reserve Banking
The idea in plain words
Commercial banks create most money by lending: a loan credits a new deposit, and repayment destroys it. Lending is limited by capital and leverage rules, liquidity rules, creditworthy borrowers and the policy rate, not by a reserve ratio.
Key points
■When a bank lends you $20,000 it credits $20,000 to your deposit account and records a $20,000 loan as its own asset; it does not take the money from a vault or another customer.
■The Bank of England’s 2014 article “Money creation in the modern economy” states plainly that a bank making a loan simultaneously creates a matching deposit.
■Under Basel III the Liquidity Coverage Ratio requires enough high-quality liquid assets to cover expected cash outflows over a 30-day stress, at a minimum of 100%.
A closer look
Here is the part most people, and many textbooks, get backwards. When a bank lends you $20,000, it does not take $20,000 out of a vault or out of another customer’s account. It credits $20,000 to your deposit account and records a $20,000 loan as its own asset. Both sides of its balance sheet grow at the same moment, and money exists that did not exist a second earlier. The Bank of England put it plainly in its 2014 Quarterly Bulletin article “Money creation in the modern economy”: “Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.” The balance in your checking account is, for the most part, money a commercial bank created, not money a central bank printed.
A worked example
Worked Example: One $20,000 Car Loan in Three T-Accounts
A T-account lists what an entity owns (assets) and what it owes (liabilities); every transaction changes both. Follow a household that borrows $20,000 from First Bank and buys a car from a dealer who banks at Second Bank. The three ledgers are the household, its commercial bank, and the central bank (the Fed). Step Household First Bank Federal Reserve 1. Loan made Assets: deposit +$20,000 Liabilities: loan +$20,000 Assets: loan +$20,000 Liabilities: household’s deposit +$20,000 No change 2. Car bought Assets: deposit −$20,000; car +$20,000 Assets: reserves −$20,000 Liabilities: household’s deposit −$20,000 Liabilities: First Bank’s reserves −$20,000; Second Bank’s reserves +$20,000 3.
What the full article covers
In the full article I take you through these sections:
■3.1 What Banks Actually Do
■3.2 How Banks Create Money — Fractional Reserve Banking
It includes worked examples, a recap, a reveal-on-click quiz and the official sources behind every figure.
Volume I: Global Economy
Read the full article on FinoLib
The complete article, Fractional Reserve Banking Explained: How Banks Create Money, with every worked example, diagram, quiz and source, is free to read in Volume I, Global Economy on finolib.com.
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