I read somewhere that money is created through lending in America, and did some googling and chating with GPT. I still have a hard time understanding how money is created by banks through lending. Somehow when a new loan is made, an equal an opposite liability is made and the Reserve creates that additional money?
Does this mean that when I get a new line of credit, that new money is created? Can someone clarify how new money is created here?
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Oh this is one I’m good at and it’s a great question that everyone should try to understand the answer to. It works the same in all countries BTW, not just the USA.
First of all, there’s real “cash” money. This is only printed by a country’s central bank. Nobody else can print cash. The central bank also has a bank account system that can be used by other banks, which is also definitely “cash” for all intents and purposes. This is the only “real” money. Everything else that is *worth* money is an asset.
Banks (not the central bank) basically work by giving you a bank account of something that *looks* like cash, but isn’t. Actually, the bank only has a small portion of *real* cash, either in an account at the central bank or as physical money in a vault somewhere. This is called fractional reserve banking.
For all intents and purposes, you don’t notice that this isn’t real cash because any time you go to an ATM, you can always withdraw real cash. Likewise, if you make a transfer to another bank, it (generally) always succeeds.
The reason this works is that the banks don’t need a lot of real cash to operate. On average, people deposit cash at branches and withdraw it at ATMs at the same rate, and even then it’s only a very small amount every day compared to the total amount of deposits. When they need to send real cash to other banks to honour your bank transfers, those other banks tend to be sending a similar amount of real cash to your bank to honour *their* customers’ bank transfers. Banks avoid having to actually send each other a lot of real cash by using a clearing house, which is just a single middleman that figures out what every bank owes each other at the end of every day so they only need to settle the difference, which is a much smaller amount of real cash.
So, a bank only needs to hold onto a certain amount of cash “to keep things smooth” which is set by regulators as a *reserve requirement.*
If a bank has a 10% reserve requirement, it could tell all of its depositors that they have $10m fake cash in the bank even if the bank only has $1m real cash. So where did $9m of people’s deposits go if the bank doesn’t have it anymore? Well, that’s where your question comes in, they actually made that $9m up and gave it to themselves to lend to people.
Basically, the bank creates new fake cash and puts it in their bank account to either buy assets with or lend it out to someone and count the IOU as an asset (effectively the same thing.) They keep the profits from these assets and so long as everybody can still withdraw from an ATM or make bank transfers, nobody notices that 90% of the money is fake! That’s because all of the assets they bought (loans they made) with their fake money are worth at least $9m, so they *could* sell them for $9m of real cash or wait for the cash to be paid back.
So hang on, banks are just printing fake money and making loans with it? What happens if the loans go bad? Doesn’t that mean they won’t ever be able to sell their assets for enough cash to be able to pay depositors back?
Well, that’s exactly what happened to some banks in 2008. This is called becoming *insolvent.* This is why banks aren’t *meant* to fail: it’s not really fair for them to make profits whilst normal people potentially take the loss. The cash in the bank should be as good as real cash to you and me otherwise the whole system doesn’t really work.
So there are two solutions: capital requirements and deposit insurance schemes.
Capital requirements say that the bank needs to have a minimum ratio of capital (how much of everything the bank actually owns outright) to the total amount of “risk-weighted” assets. This means that as a bank you should always have enough money to lose if your loans default (at some sensible rate) and at the very least regulators will have plenty of warning to force you to sell everything if things start to get tight (normally to another bank who can hold them more safely.) Banks need to keep reporting this ratio to the regulators, so they can’t secretly be about to fail or take stupid risks and suddenly go bust (like they used to.)
Deposit insurance schemes are the last line of defense. It’s an insurance that covers depositors, normally up to a limit, in case the bank really does go bust and can’t pay them back. This gives consumers more confidence that their fake bank cash is as good as real cash.
So there, that’s how banks can effectively multiply the amount of money in an economy! The reserve requirements are actually a control that regulators can use to expand or limit money supply, but generally they are set high enough to try and prevent a bank run whilst being low enough to let the banks actually do what they do: leverage your money at a high ratio to make tasty profits, or potentially nasty losses; or make important investments in our economy, whichever floats your boat.
ETA As another commenter pointed out, the real cash is M0 and the fake cash is M1 and the reserve requirement sets the money multiplier from M0 to M1.
Very ELI5.
When a loan is made, a bank does it by using its resources(including customer deposits at a certain percentage depending on the laws in their jurisdiction).
If that’s not enough, let’s say the interest rates are very low and everybody rushes for credits, then a bank also borrows from the central banks/commercial banks.
Central Banks have enough liquidity to lend to these banks. If that’s not enough, they simply print.
What you’re asking about is called *fractional reserve banking*. Here’s how it works:
Bob has a bank. 10 people each deposit 10 gold coins in his bank. In exchange, each of those people get a piece of paper that says “Bank statement…Balance…10 coins”. Which can be rephrased as “IOU 10 gold coins – Bank of Bob”.
One day Harry Homebuyer borrows 80 gold coins from the Bank of Bob and uses them to buy a house from Sally Seller. After the transaction goes through, here are the facts:
– There are 20 gold coins in the vault at the Bank of Bob.
– There are 80 gold coins in Sally’s purse.
If we say “Money = gold coins,” then there are still 100. No new gold coins were created.
But if you go around asking people how much money they have, a funny thing happens.
– When you interview Sally, she says “I have 80 gold coins. I can prove it, they’re right here in my purse.”
– When you interview the 10 depositors at the Bank of Bob, they each say “I have 10 gold coins. I can prove it, I have a statement from the Bank of Bob right here.”
Adding up how much money people think they have, you get 180 gold coins. That’s because we changed the definition to “Money = gold coins outside of bank vaults + bank deposits.”
Bob’s vault actually contains two things:
– 20 coins
– A piece of paper called a *mortgage* that says “I will pay you 2 gold coins a year for the next 30 years — Harry Homebuyer.” Which we can shorten to “IOU 200 gold coins (over 30 years) – Harry Homebuyer.”
Bob is hoping that either (a) no more than 20% of his depositors ask for their gold coins back at a time, or (b) he can get more gold coins by selling the IOU from Harry Homebuyer to another bank.
(For a variety of reasons, the US has replaced “gold coins” with “green pieces of paper printed by the government.” The government printing more green pieces of paper, or miners digging up gold out of the ground *also creates money* but is a *fundamentally different process from fractional reserve banking*.)
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