How do banks create money?

14/10/2010 23:36

Bankers know how to create money out of thin air. In fact, banks are money factories. Banks exist to make money. You might think that banks are in business to provide services such as banking accounts and loans to their customers. It's true that banks provide essential financial services. However, the reason that the banks provide such services is that banks need money to use as raw material to create more money. Where does this money come from? It comes from customer deposits. In other words, it comes from the money you and I deposit into the bank.

Notice very carefully, banks "create" money. It's not simply that banks "earn" profits when they provide bank services and loans. Banks actually "create" new money that did not exist before.

Here is an example of how banks create money. You deposit $100,000 into a one-year Certificate of Deposit at 5% interest. The bank now can use your money to create loans.

The Federal Reserve sets the reserve rate for the bank from 3-10%. A 3% reserve rate means that the bank must keep 3% of the $100,000 on reserve and can loan the remaining 97%. A 10% reserve rate means that the bank must keep 10% of the $100,000 on reserve and can loan the remaining 90%. For our example, let's assume that the reserve rate is 10%. This allows the bank to loan $90,000 of your $100,000 deposit.

So, the bank makes Loan #1 of $90,000 and keeps $10,000 on reserve. This is the critical point where the bank creates money. According to the bank's balance sheet, the $90,000 loan to the borrower is also a $90,000 asset for the bank. By its own brand of money magic, the bank has created $90,000 out of thin air.

But the process does not stop here. Since the bank now has an asset of $90,000, it can make another loan based on this asset. Since the same Federal Reserve rules apply, the bank must keep 10% of this asset on reserve. This means it can loan only 90% of the $90,000. This means that Loan #2 is $81,000. By creating another loan, the bank has created another asset. The $81,000 loan to the borrower becomes an $81,000 asset for the bank. Once again the bank creates money out of thin air.

And since the bank now has an additional $81,000 asset, it can make another loan. Once again, the bank must keep 10% of this asset on reserve. This means it can loan only 90% of the $81,000 asset. Loan #3 is $72,900.

Federal Reserve rules allow the bank to make five to six loans based on the original $100,000 deposit. Each loan creates an additional asset. We'll stop at three loans, review the process, and add up how much money the bank has created.

You deposit $100,000 into a CD. The bank creates three loans based on the original $100,000 deposit. Loan /Asset #1 = $90,000 Loan/Asset #2 = $81,000. Loan/Asset #3 = $72,900. The total = $243,900 in assets for the bank. This is $243,900 in new money.

When you cash out your CD, you get your $100,000 deposit back, in addition to the $5,000 interest. Meanwhile, the bank has created $243,900 of new money. After it pays you 5% interest, the bank has made a tidy profit of $238,900. ($243,900 - $5,000 = $238,900.) If the numbers are confusing, go over them again until you see how magical this process is. This is how banks create money.

To make this point, I have oversimplified the process. A bank doesn't really make a series of separate loans based on a single deposit. Your deposits become part of a pool of money the bank can use to make loans. But this oversimplified example demonstrates how banks create money out of thin air. A bank manufactures money by using the deposits of customers to make loans. The loans become assets and the assets turn into money.

What difference does it make to see how banks use money to create money? You and I can't do what banks do, by loaning on the same money more than once. The real point of this example is to take some of the mystery out of money.

The process a bank uses to create money demonstrates that money is not a commodity in limited supply, where there is only so much to go around. Money is not equivalent to currency. Money is created in money-making transactions, which means there is no potential limit to money.

So, if you want more money, think the way bankers think. Ask how you can use money to create more money. If you really think the way bankers think, you will use someone else's money to create more money. The crucial idea behind all of this is: The greatest limit to money is the belief that money is limited.

Kalinda Rose Stevenson, Ph.D. Discover the difference between earning money and making money in a real estate investing book, "No Money Limits." Visit http://www.NoMoneyLimits.com for your Free "52 Heart of Money Insights."

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