In this article, I give you my quick explanation of how banks make money out of nothing. A topic that has always fascinated me.
How is it possible that you never happen to come to the bank and get the answer that you can’t get a loan because they don’t have enough money at the moment. To tell you that they have to wait for someone to deposit (term) money so they can issue new loans.
From the text below you will see how things really work and how a bank can create a new 3, 5, or 10 dollars from your one dollar. Of course, the opposite is also true: by withdrawing money from the bank, you reduce the possibility of its multiplication (GH).
How can a bank “create” three from one dollar? Is it some magic wand with which banks create money or is something else hiding?
From its earliest beginnings, the financial system is based on the principle of supply and demand, ie the confrontation of surpluses and shortages of financial resources.
In ancient times, when banks did not yet exist and when money or gold was kept by goldsmiths, it was realized that goldsmiths did not need to keep all the gold, but that a good part could be lent to those who needed it, and that only a small part could be kept for settlement of current liabilities.
So now, in addition to the fees for storing gold in their safes, they have also started charging interest on borrowed surpluses. It is on this principle that today’s modern banking system has developed.
The operations of today’s banks are based on collected deposits – meaning surplus funds of households, companies, and other entities.
Deposits thus collected represent the bank’s liability in its liabilities. The bank must set aside a part of the funds in the form of required reserves and liquidity reserves (prescribed by the National Bank – NB) in order to be able to fulfill its obligations, while the rest of the funds can be placed in the form of loans to its clients or other forms of investment.
So we see that the bank actually transfers its own liabilities – received deposits (liabilities) to its own receivables – loans (assets).
The misconception is that banks base their profitability on the difference between deposit (interest on received deposits) and active (interest on loans) interest rates while thinking that the bank on the received deposit of say $100 dollars approve a loan in the same or less amount. This of course is not even close to true and below we will see why.
If a bank collects USD $100 of a deposit and sets aside USD $20 for the required reserve and USD $10 for the liquidity reserve, it is left with USD $70 for lending activity and this is its current credit potential. Assuming that the bank manages to place all USD $70 in the form of a loan, one part of the approved approval will be returned or remain in the bank’s account (retention rate in the bank).
Assuming that $30 dollars from the originally approved loan is returned to the bank, that $30 dollars represent a new deposit and a new basis for the next loan. The bank thus multiplies its value on the basis of one deposit and performs credit expansion.
Let us not forget that this was an example of a model of one bank (bank A) where there was an assumption that $30 would remain and/or return to the bank.
In this way, we come to the so-called macro multiplication or expansion of loans at the level of all banks where banks on the basis of the initial $100 deposit can approve a much higher loan amount and, of course, charge an active interest rate on the total amount.
Therefore, we say that banks create deposit money ( money in accounts ) while the central bank creates primary or effective money ( banknotes and coins ) through the primary issues.
The lending activity on the basis of which the deposit money is created is in fact a secondary issue of money. It is important to emphasize that the process of multiplication is also influenced by the development of non-cash payment operations. The more developed non-cash payment operations, ie the less effective money in circulation, the higher the credit base will be.
The NB, as the regulator of monetary policy, pays special attention to the fact that this multiplication process is not too unrestrained, so it influences the process of deposit multiplication with various restrictive measures.
Of particular importance here are the ones already mentioned: the reserve requirement rate and the liquidity reserve. The lower these rates the credit expansion will be higher and vice versa.
Of course, there are conflicting opinions between commercial banks that seek to maximize their credit potential and thus their profitability, and the central bank that seeks to limit credit expansion and avoid possible economic shocks.