I don’t get it. I don’t get it. I don’t get it. I don’t get it.
When a bank makes a $1,000 loan, that creates $1,000 in the recipient’s account, but I don’t get how the loan, the absence of money, is an asset on the lending bank’s books. If it’s because the money will be paid back, then isn’t it’s value based on a corresponding debit of the recipients account thus nullifying the created money?
Edit: I am not asking how banks make a profit. I get that. I am asking how NEW DOLLARS are created. There are more dollars in existence now than there were say 100 years ago. I want to understand how they came to be. The answer I’ve found so far is that NEW DOLLARS are created when a commercial bank makes a loan.
Second Edit: For those saying commercial loans don’t create new dollars, apparently they do, but I don’t get it. For reference:
https://positivemoney.org/how-money-works/proof-that-banks-create-money/
In: 23
The fractional reserve banking system! Very simple example – you’re the only bank in town and you have $100 in cash ($100 in equity funding $100 in cash assets i.e. “money today”). You lend that cash to a small business. You still have $100 in equity now funding $100 in loans (“money tomorrow”). The small business then takes that cash and deposits it back to you. You now have $200 in assets – $100 in cash and a $100 loan – offset by $100 in liabilities and $100 in equity. But now TWO people in town have $100 – you and the person you loaned to. So you’ve just created $100!
The illusion that enables this is pretending that the $100 in deposits are both your money and the small business’s money. To the small business, it’s as good as cash, but practically speaking that’s not true. It’s only cash once the small business withdraws it. It’s like saying you and your cousin both have a car so there’s two cars – but in reality you just borrow the car when your cousin isn’t using it. This illusion is called “maturity transformation” – the bank transforming “money today” into “money tomorrow” but pretending its all the same.
This cycle could in theory continue infinitely. You could lend out the cash, they deposit it, you lend it back out, etc. etc. until there’s infinite money – everyone in town has a $100 loan from the bank that they then deposited back. HOWEVER, this is very precarious. Going back to the car metaphor, it’s fine to pretend as long as only two people want to use the car and one uses it to commute on weekdays and the other uses it to travel on the weekend. But if there’s 10 people trying to use the car, it becomes very difficult to pretend there’s 10 cars. Inevitably two people are going to want to use it at once, and then the “illusion” comes crashing down. Back in bank-land, this constitutes a “run on the bank” (a la ‘It’s a Wonderful Life’). As soon as people try to withdraw their deposits and can’t, the music stops. People have to reckon with the fact that their only ever was $100. To pay back a depositor, the bank has to “call” a loan – to pay back the loan the borrower needs to withdraw their deposit – etc. etc. until the whole thing unwinds.
Regulatory capital requirements are intended to put a cap on how many times you can do this. Set as they are around 10%, it means banks can effectively do this cycle 10 times (i.e. turn $100 in new cash into $1000 in loans). The assumption there is no more than 10% of people are going to want to be really actively doing something with their cash at any point in time. But in extraordinary circumstances, obviously that can change.
Now this is a very simplified example that doesn’t take into account the concept of credit risk and considers a world with only two of the most basic banking products. But hopefully gives an idea of how the money wheel goes round.
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