How Banks Really Lend Money

Front view of a large bankHow do banks lend money? Most people have the preconceived notion that it is from their deposits. At least that is what economics 101 teaches us.

The Presumed Way

Most people think banks operate this way:

A bank opens and customers in the surrounding area come in and deposit their earnings.

After a while, the bank is sitting on a pile of money. It lends out the deposit money for mortgages, business ventures, and other worthwhile projects.

As the interest and principal is paid back, the bank accumulates even more money to lend.

The banks make money by charging more on loans than they pay on deposits.

The cycle repeats.

But that is not how it works.

The Actual Way

Some money, called reserves, is held back so people wanting to cash in their deposits or write checks can do so. In the recent past banks had to have 10% of their deposits in reserve (in their vaults) for depositors wanting their money. This requirement is set by the Federal Reserve board.

An example will illustrate this best.

  1. $100 is deposited in the bank.
  2. With 10% reserves, the bank can lend out $90 and put  $10 in reserves.
  3. The bank loans $90 to customer C1 who pays C2. C2 deposits in the bank.
  4. Now the bank has $81 to loan, $9 to reserve. The bank loans $81 to customer C3 who pays C4. C4 deposits it in the bank.
  5. Now the bank has $72.90 to loan, $7.10 to reserves....
  6. In the end the bank has loaned out $900 (which is paying interest) and has $100 in reserve.

What happens if a lot of depositors show up for their money? In the past, the bank would go out of business because it could not meet the demands of the depositors. Now it can borrow from the Federal Reserve - as a last chance loan.

How did this come about?

It all began in seventeenth century Europe. Trade was conducted primarily using gold and silver coins. Easy to steal, they were kept in the safest place in town: the goldsmith's safe. He issued paper receipts for the deposits made. Through trial and error the goldsmiths discovered that they only had to keep 10% of the gold in the safe to take care of people redeeming receipts. With this information, they lent out more receipts than they had gold in their vault. This type of lending, called fractional reserve banking, is still carried on today using paper money rather than gold.

Update

These days (2009) there is evidence that the Fed does not require the reserves anymore. Why? Because the lending bank can borrow from the Fed at a low rate (the Federal funds rate) there is little reason to keep much money in the vault.

Read Ellen Brown's Web of Debt for an almost unbelievable description of the United States money system.

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