How Banks Use Your Money To Make New Money
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.At this point, the choice of vocabulary is critical. Banks are not just “earning” money. Banks are actually “creating” new money.
For example: You deposit $100,000 into a one-year Certificate of Deposit at 5% interest. Your money now becomes raw material for bank 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.
This is the point where the bank does its money magic. It makes a $90,000 loan to a borrower. Now, this $90,000 loan goes on the bank’s balance sheet as a $90,000 asset. This is the critical point at which the bank creates money out of thin air.
The bank does not have to stop with one loan. Since it now has an asset worth $90,000, it can use this asset to make another loan. Again, it must keep 10% on reserve, which means that it can loan 90% of the $90,000. So the bank makes a loan of $81,000. Once again, the bank has created money out of thin air. The $81,000 loan becomes an $81,000 asset.
By now, you can predict the process. The bank uses the $81,000 asset to make an additional loan. After taking out the 10% reserve, the bank can make another loan worth $72,900. In the process, it creates an additional asset. This asset is worth $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.
This example is oversimplified, but the principle behind the example demonstrates how banks create money out of thin air. When you deposit your money into the bank, it goes into a pool of money available for the bank to make loans. When the bank creates a loan, it creates an asset. This asset is new money.
The purpose of this example is to demystify money. You and I cannot do what banks do. We can’t make multiple loans based on the same money. The value of seeing how banks use customer deposits to create money is to understand how money is created.
The critical point is to see that money is not a commodity. Money is not equivalent to currency. Money is created in money-making transactions.
The point in all of this is that bankers understand something about money that most of us don’t know. Bankers know how to create money. They know that the greatest limit to money is the belief that money is limited. If you want more money, ask how you can create money. The real question is: How can think the way a banker thinks? How can you use someone else’s money to create more money?
Tags: Bank Owned Market