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Traditional introductory economic textbooks generally treat banks as financial intermediaries, the role of which is to connect borrowers with savers, facilitating their interactions by acting as credible middlemen.
Individuals who earn an income above their immediate consumption needs can deposit their unused income in a reputable bank, thus creating a reservoir of funds. The bank can then draw on those from those funds in order to loan out to those whose incomes fall below their immediate consumption needs. Read on to see how banks really use your deposits to make loans and to what extent they need your money to do so.
- Banks are thought of as financial intermediaries that connect savers and borrowers.
- However, banks actually rely on a fractional reserve banking system whereby banks can lend more than the number of actual deposits on hand.
- This leads to a money multiplier effect. If, for example, the amount of reserves held by a bank is 10%, then loans can multiply money by up to 10x.
How It Works
According to the above portrayal, the lending capacity of a bank is limited by the magnitude of their customers’ deposits. In order to lend out more, a bank must secure new deposits by attracting more customers. Without deposits, there would be no loans, or in other words, deposits create loans.
Of course, this story of bank lending is usually supplemented by the money multiplier theory that is consistent with what is known as fractional reserve banking.
In a fractional reserve system, only a fraction of a bank’s deposits needs to be held in cash or in a commercial bank’s deposit account at the central bank. The magnitude of this fraction is specified by the reserve requirement, the reciprocal of which indicates the multiple of reserves that banks are able to lend out. If the reserve requirement is 10% (i.e ., 0.1) then the multiplier is 10, meaning banks are able to lend out 10 times more than their reserves.
The capacity of bank lending is not entirely restricted by banks’ ability to attract new deposits, but by the central bank’s monetary policy decisions about whether or not to increase reserves. However, given a particular monetary policy regime and barring any increase in reserves, the only way commercial banks can increase their lending capacity is to secure new deposits. Again, deposits create loans, and consequently, banks need your money in order to make new loans.
In , the Board of Governors of the Federal Reserve System reduced reserve requirement ratios to 0%, effectively eliminating them for all depository institutions.?
Banks in the Real World
In today’s modern economy most money takes the form of deposits, but rather than being created by a group of savers entrusting the bank withholding their money, deposits are actually created when banks extend credit (i.e., create new loans). As Joseph Schumpeter once wrote, “It is much more realistic to say that the banks ‘create credit,’ that is, that they create deposits in their act of lending than to say that they lend the deposits that have been entrusted to them.”
When a bank makes a loan, there are two corresponding entries that are made on its balance sheet, one on the assets side and one on the liabilities side. The loan counts as an asset to the bank and it is simultaneously offset by a newly created deposit, which is a liability of the bank to the depositor holder. Contrary to the story described above, loans actually create deposits.