How Banks Create Money

Ever wonder really happens when you deposit your paycheck in your bank account?  Or what about your car loan or home equity line of credit, where did that money come from?  You probably get paid interest for having your money on deposit with a bank or credit union, but why would the banks care about your savings?

The big confusing word behind how all of this works is “fractional reserve banking.”  Our banks operate on this system which requires them to only keep a fraction of their deposits in reserves.  For example let’s say you deposit $1,000 in your account at your bank.  The bank takes the $1,000 out of your account and replaces it with a bank IOU for $1,000 (this is all invisible to you).  Then they take the 90% of the deposit ($900) and lend it out in the form of car loans, mortgages, or anything other debt product.  The remaining 10% ($100) is put in the banks reserves.  Sounds crazy right?  Well it’s about to get a lot crazier…

Continuing with the above example, the total money supply has increased from $1,000 to $1,900.  Where did the extra $900 come from?  The bank created it out of thin air! Summarizing the current example, the bank has put $100 of your deposit in reserves, lent out $900 of it, and created $1,000 by giving you an IOU for the amount deposited.  In fact, your deposit at the bank (called a “demand deposit”) is legally considered a loan to the bank repayable on demand.

In practice the $900 lent out would find it’s way to another bank as a demand deposit.  That bank would then keep 10% in reserves, lend out 90%, and the whole process would repeat again and again.  Yikes!

So what if you want your $1,000 back?  No problem… at least if everything goes according to plan.  The fractional reserve system relies on the statical improbability that a large number of depositors will want their money back at once.  If they do it’s called a run on the bank and the bank will likely collapse (now days we have the FDIC to guard against this, more on that later)!

By putting 90% of demand deposits to work the bank is able to make a tidy spread on what it pays in interest (your savings rate) and what it collects in interest (your mortgage rate).  That’s what buys your bank C.E.O his house in the Hamptons

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