Where Do Banks Get Their Money? Fractional Reserve Banking

Posted on 09.30.08 in category Banking

Do Banks Create New Money out of Thin Air?

**Re-posted after the events of the credit crunch and 700 bailout packages, enjoy the read and learn how the banks got themselves in this mess.**

Here's the story. Banks keep on lending money, but where do they get it from? Do they borrow from bigger banks who borrow from bigger banks who borrow from the central bank who then prints the money? Is it as simple as just printing more money?

Turns out money creation sometimes appears out of thin air. All banks lend based on a reserve ratio of their deposit: they must keep a certain % of each deposit at the bank but can lend out the rest. Of course, the whole system is dependent on a) the bank being responsible with lending, b) everyone not defaulting on their loans. If these two things happen eventually the system faces massive losses which is what we're seeing in the current market.

Let's observe a fictitious situation to help us understand how the bank gets or 'creates' their money. Note: when the term 'bank' is used in this article it will refer to your bank and not the central bank (Federal Reserve for the US.)



Let's build a scenario where there is on bank called National Bank (operating as a monopoly). Suppose a person in another country sends $1000 and they deposit it into the bank. This becomes a NEW deposit for the bank (a PRIMARY deposit).

BANK:

Assets

Liabilities

Cash +1000

Demand Deposit +1000

(Primary Deposit)

(Increase in money supply (Ms))

At this point there is no change in the Ms (money supply), only the composition of it. M1 outside bank to M1 in demand deposits.

The bank will now: A) Keep a little in reserve to meet cash demands, B) Lend the rest out to worthy borrowers.

Let's assume the Bank has a desired target reserve ratio of .15 (15%) to cover customer cash demands (when you go to the bank and withdraw cash). For $1000 they will keep $150 and lend out $850.

When someone borrows the $850, eventually it will reach the bank again (unless they put it underneath their mattress). Remember we are in a one bank scenario (monopoly).
Bank Now Has:

Assets

Liabilities

Cash +1000

Demand Deposit +1000

Loan +850

850

Total $1850

Total $1850

The total Ms is now $1850.

The Bank holds 15% of 1850 in reserve & lends the rest out. This process repeats itself indefinitely until they can no longer lend out money. This whole concept is called: DEPOSIT CREATION MULTIPLIER.

A quick way to determine the theoretical maximum a bank can lend out is this formula:

New Deposit / Target Reserve Ratio =

ex. $1000 / .15 = $6666.67 in new deposits (Ms increases by this much as well).

The theoretical maximum of course depends on whether the target reserve ratio is correct. Some things that affect the max include: a) number of worthwhile borrowers, b) no currency drain, c) no precautionary balances, d) no clearing drain.

Here are some additional items that may affect how much money the bank can create.

Deposit Creation Multiplier (Modifications)

Base case --> $1000 / .15 = $6,666.67

1) Suppose a 5% currency drain = money supply will only expand to $1000 / .15 + 0.05 = $1000/ .20 = $5000

- Final position of bank -
Assets Liabilities
Cash $750 Deposits $5000
Loans $4250

2) Suppose the banks decide to hold additional precautionary balances of 5%
Ms only expand to = $1000/ .15 + .05 + .05 = $4000

3) Suppose banks have foreign currency deposits and choose to hold additional reserves of .02 (2%)

Ms will (only expand to): $1000 / .15 + .05 + .05 + .02 = $3, 703.70

These are simplistic examples of how banks create money using the scenario of a single Bank acting as a monopoly in the banking industry. It may seem like money is created out of thin air but that's not exactly the case because behind every loan is an asset. Huge trouble develops when the asset becomes worthless (many homes); someone needs to face all the losses.

Also, this does not highlight how the Federal Reserve creates money, they can actually print more money but, again, it's not out of 'thin air', it's based on the debt created by a debt note usually in the form of a government bond.

Read another related article to money and banking located here.


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  • Mike

    What is the 850 liability in the second balance sheet? Since the bank has sold a 850 loan without giving up any cash because who ever the bank lent it too put it straight back into the bank then both the capital and the interest are profit. Profit is still a liability but it is money owed to the shareholders. Have I understood correctly?

  • aussietone

    well put, short and sharp. Yes I'm nearly there, Idon't own much but I'm practically debt free. and it is a feeling of self power, but as a double edged sword it can feel a little less of a man etc. Just keep thinking beyond the materialistic urge we were warned against and things start to feel better.

  • aussietone

    Well that is precisely the way it should have stayed, as it was in Australia up until the 90's when banking deregulations started to take hold. Fortunately our Reserve bank over here is not a privately organised one like in the USA. We should all remember that not everybody should be allowed to borrow too much $ to start with. So what if there is slower growth and thus ,slower profit taking by huge banks and multinational companies. That's all it has been about. . . How the select fortunate few can maintain and continue to reap in, the vast majority of the world's economic power and control. Thus they maintain their wealthy status quo.

    If commercial banks didn't engage in such promisory notes etc. then there would be alot less people aquiring loans (of whom probably should have them anyway) there would be slower global growth (therefore less of an appetite for buying shit we don't need) and there would also be much less profit being made by "The Banks" and let's not forget the multinationals... OH NO, that can't be allowed to happen now can it. The enviroment and the resources of the earth might be stronger and more capable of sustaining us all, but instead we must all be allowed to aquire debt so we can keep a bunch of bankers, economists (no insult intended to the individual) top ranking shareholders, directors etc. and politicians rolling flush with money. The US federal reserve bank should have remained like Australia's reserve bank. . . NOT PRIVATELY RUN AND CONTROLLED .

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  • Dr. House

    You say that like it is a bad thing.

    People's willingness to sell their future life and livelihood for gratification today is the root problem (and the theme of many, many fables.)
    If people were /unwilling/ to sell their souls and instead insisted on paying themselves for the work they do and saved money they would not become wage-slaves and would be able to modulate their behavior accord to their values.
    Today 99% of the population cannot because 99% of the population so greatly wishes to live beyond their means that they compromise their values in order to do.

    FICO only matters if you are owned by a bank.
    It's a measure of how good of slave you are.
    Once you are a free man your FICO score becomes 0.

    If you live debt-free then you exit the system and make the banks one iota weaker.
    If, over time, many people stopped living in debt the system would wane in power.

    The religious undertones of all of this are difficult to ignore.
    I am an Atheist so permit me the liberty to recast God as the collective human wisdom of the ages.
    We knew better. We were warned. We didn't listen.

  • se7ensnakes

    In a foreclosure the banks exchanges a paper called a promissory note for a real assets. The trick is to get people to sign in the dotted line. Imagine that a home sells for 200k. 75k went for hiring engineers, architect, land purchase, permits and materials. Another 75k went for labor and rental equipment to aid in building the home. The contractor, subsequently, sells the home for 200k and pockets 50k for his effort. Some credit worthy customer comes along and decides they are going to buy the home and so they put up 50k for down payment and a bank finances the rest, 150k. In a matter of 15 years, depending on the interest rate, the banks would have profited 150k from the interest. The payment of the principal will eventually come unless...something happens to the debtor and he cannot fulfill his promissory obligation. Now the homes goes into foreclosure. The banks gets the house, the previous 50k down payment, all the payments the debtor made to that point. What did the bank need to do to get this deal? Just write out a check to the debtor based on the idea that he will pay it back. It is not that banks loan money from deposits but that banks loans money for deposits. In this system you can imagine why and how Washington is full of politicians who cater to these powerful institutions. The probably have controlling interest in all major companies. The future is bleak for the common worker. There does not appear to be any where to invest money for retirement. inflation will eat at it in the bank. and real estate and the stock market are primarily for the insiders that know when economy is going to take a downturn.

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