How banks create money, not from deposits

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S_Track
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How banks create money, not from deposits

Post by S_Track » Sat Mar 10, 2018 9:15 am

Hi All,

I found the article linked below where the author explained how money is created by commercial banks. It seems there has been a misconception for many years as to the process:

“While many people may think that banks take in savers’ money and then lend it out, this is a misconception. So too is the idea that money is created by the Bank of England.
Instead the Bank’s paper says that 97 per cent of broad money currently in circulation is made up of bank deposits, which it explains are essentially IOUs from commercial banks to households and companies. Banks create money by making new loans.
The money for your mortgage has not come from a pool of savers – it was created by a computer keystroke.”

Is this really how it works? If it is true, and commercial bank create deposits when they award a loan, it seems to me that loan defaults would not be too burdensome for the bank. Has the bank really lost any money if the loan is not paid back?

http://www.thisismoney.co.uk/money/comm ... s-cut.html

Thanks

bberris
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Re: How banks create money, not from deposits

Post by bberris » Sat Mar 10, 2018 9:22 am

Yes, they have lost money if a loan is not paid. The money is destroyed in a default, or even if the loan is paid back. The difference when a borrower defaults is that the bank's profits have declined by the amount of the loss, which eventually shows up in the balance sheet as a capital loss. They do care about being paid back. A capital loss is a serious thing.

Banks' loans aren't limited by their deposits but they are limited by their capital, both by regulation and prudence.

Now you see why banking is such a good business; they print money!

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Oicuryy
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Re: How banks create money, not from deposits

Post by Oicuryy » Sat Mar 10, 2018 10:52 am

Yes, deposits at banks are essentially IOUs written by banks.

When a bank makes a mortgage loan it trades an IOU that it writes for an IOU that the mortgage borrower writes. The bank still has to honor its IOU even if the borrower fails to honor his IOU. So the bank does lose if a borrower defaults.

Ron
Last edited by Oicuryy on Sat Mar 10, 2018 10:53 am, edited 1 time in total.
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BolderBoy
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Re: How banks create money, not from deposits

Post by BolderBoy » Sat Mar 10, 2018 10:53 am

bob_m10 wrote:
Sat Mar 10, 2018 9:15 am
Is this really how it works? If it is true, and commercial bank create deposits when they award a loan, it seems to me that loan defaults would not be too burdensome for the bank. Has the bank really lost any money if the loan is not paid back?
Warning - this info is from the mid-1970s and my understanding of finances was very low. I had a brother-in-law who was a bond broker and investment banker with a variety of the "big name" investment banks on Wall Street. His simplified explanation of the big picture was that everything banking revolved around "settlement day" - I think he said it was Wednesday each week. On settlement day all banks' books had to balance "to the penny" and the settlement day books are what the federal regulators would examine without warning. So, in addition to their regular banking practices, the banks were furiously lending money to each other (often $100s of millions) for very short periods of times to make their books balance. He related how one of his office mates blew off the Tuesday before one settlement day and went home early, leaving $250 million unloaned overnight. The interest lost on that 1-2 day loan cost the guy his job.

So yeah, loans to individual humans are paltry by comparison with what the banks lend to each other but I think it is a misnomer to say that banks "print money".
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dm200
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Re: How banks create money, not from deposits

Post by dm200 » Sat Mar 10, 2018 11:12 am

While there some differences in the US between banks and credit unions, I know the ins and outs of how individual credit unions work.

Credit unions take deposits from members and either lend it out or invest in safe things (bonds for example). If there are not enough deposits for its needs, then a credit union can (to a certain degree) borrow money and (just as funds from a deposit) lend or invest.

If a loan is not paid back, that is a real loss to the credit union. If many loans are not paid back, that can be serious and could lead to the credit union failing.

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Re: How banks create money, not from deposits

Post by S_Track » Sat Mar 10, 2018 11:28 am

Oicuryy wrote:
Sat Mar 10, 2018 10:52 am
Yes, deposits at banks are essentially IOUs written by banks.

When a bank makes a mortgage loan it trades an IOU that it writes for an IOU that the mortgage borrower writes. The bank still has to honor its IOU even if the borrower fails to honor his IOU. So the bank does lose if a borrower defaults.

Ron
Who does the bank write an IOU too, is it the mortgage borrower before he takes the loan?

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Re: How banks create money, not from deposits

Post by S_Track » Sat Mar 10, 2018 11:31 am

bberris wrote:
Sat Mar 10, 2018 9:22 am
Yes, they have lost money if a loan is not paid. The money is destroyed in a default, or even if the loan is paid back. The difference when a borrower defaults is that the bank's profits have declined by the amount of the loss, which eventually shows up in the balance sheet as a capital loss. They do care about being paid back. A capital loss is a serious thing.

Banks' loans aren't limited by their deposits but they are limited by their capital, both by regulation and prudence.

Now you see why banking is such a good business; they print money!
Found this from Money for the rest of us, podcast. I believe the statements below go along with your explanation of the capital loss. I am not an accountant so still trying to piece this together.

"What happens when a bank makes a loan?
The bank also records a loan receivable on its balance sheet as an asset. But here is where things get a little creative. When the loan is funded, the bank doesn’t reduce its cash balance like a non-bank does. Instead the bank records a customer deposit as a liability on its balance sheet in the same amount of the loan. That means the bank’s balance sheet expanded by the loan amount. "

https://moneyfortherestofus.com/mny094- ... stroyed-2/

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Oicuryy
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Re: How banks create money, not from deposits

Post by Oicuryy » Sat Mar 10, 2018 11:53 am

bob_m10 wrote:
Sat Mar 10, 2018 11:28 am
Who does the bank write an IOU too, is it the mortgage borrower before he takes the loan?
The money that the borrower gets is an IOU from a bank. Essentially any money that is not paper currency is an IOU from a bank.

Bank-written IOUs function as money because they are easily transferred at face value. Any time you write a check or use a debit card you are changing the payee on a bank-written IOU from you to someone else.

Ron
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Re: How banks create money, not from deposits

Post by cjking » Sat Mar 10, 2018 12:44 pm

I was reading this recently on the Bank of England web site. How most money is created: at the point a bank credits x dollars from a new loan to a customer account, x dollars have just been created out of thin air.

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dm200
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Re: How banks create money, not from deposits

Post by dm200 » Sat Mar 10, 2018 1:11 pm

cjking wrote:
Sat Mar 10, 2018 12:44 pm
I was reading this recently on the Bank of England web site. How most money is created: at the point a bank credits x dollars from a new loan to a customer account, x dollars have just been created out of thin air.
There is a big difference between money being "created" overall in the economy vs any individual bank or credit union's balance sheet.

Unless I am missing something, when a bank or credit union makes a loan - the balance sheet (assets and liabilities) bottom line stays the same.

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Re: How banks create money, not from deposits

Post by cjking » Sat Mar 10, 2018 1:41 pm

Here is the article

https://www.bankofengland.co.uk/-/media ... conomy.pdf

Quote from the introduction, with my bold.
In the modern economy, most money takes the form of bank
deposits. But how those bank deposits are created is often
misunderstood: the principal way is through commercial
banks making loans. Whenever a bank makes a loan, it
simultaneously creates a matching deposit in the
borrower’s bank account, thereby creating new money.

The reality of how money is created today differs from the
description found in some economics textbooks:
• Rather than banks receiving deposits when households
save and then lending them out, bank lending creates
deposits.
• In normal times, the central bank does not fix the amount
of money in circulation, nor is central bank money
‘multiplied up’ into more loans and deposits.
Although commercial banks create money through lending,
they cannot do so freely without limit. Banks are limited in
how much they can lend if they are to remain profitable in a
competitive banking system. Prudential regulation also acts
as a constraint on banks’ activities in order to maintain the
resilience of the financial system. And the households and
companies who receive the money created by new lending
may take actions that affect the stock of money — they
could quickly ‘destroy’ money by using it to repay their
existing debt, for instance.

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Re: How banks create money, not from deposits

Post by cjking » Sat Mar 10, 2018 1:54 pm

dm200 wrote:
Sat Mar 10, 2018 1:11 pm
Unless I am missing something, when a bank or credit union makes a loan - the balance sheet (assets and liabilities) bottom line stays the same.
I think that's right, two things of equal value are created, which offset each other. But only one of the two things is money, therefore the amount of money in the economy has changed.

A corollary of the fact that money is created whenever a loan is made is that money is destroyed whenever it is repaid.

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F150HD
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Re: How banks create money, not from deposits

Post by F150HD » Sat Mar 10, 2018 2:08 pm

Recent Schwab article came to mind reading this thread...1:48 in video

Yield Curves Explained
FIXED INCOME
MARKET COMMENTARY BONDS
MARCH 07, 2018

bberris
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Re: How banks create money, not from deposits

Post by bberris » Sat Mar 10, 2018 2:28 pm

dm200 wrote:
Sat Mar 10, 2018 1:11 pm
cjking wrote:
Sat Mar 10, 2018 12:44 pm
I was reading this recently on the Bank of England web site. How most money is created: at the point a bank credits x dollars from a new loan to a customer account, x dollars have just been created out of thin air.
There is a big difference between money being "created" overall in the economy vs any individual bank or credit union's balance sheet.

Unless I am missing something, when a bank or credit union makes a loan - the balance sheet (assets and liabilities) bottom line stays the same.
The terminology is a little confusing. When a loan is made, assets and liabilities increase by the same amount. Capital has not changed. But the borrowers checking account (or the guy he paid the loan proceeds to) has a corresponding larger balance; the money supply has increased. Capital is not money, it is the excess of assets over liabilities.

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dm200
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Re: How banks create money, not from deposits

Post by dm200 » Sat Mar 10, 2018 2:58 pm

bberris wrote:
Sat Mar 10, 2018 2:28 pm
dm200 wrote:
Sat Mar 10, 2018 1:11 pm
cjking wrote:
Sat Mar 10, 2018 12:44 pm
I was reading this recently on the Bank of England web site. How most money is created: at the point a bank credits x dollars from a new loan to a customer account, x dollars have just been created out of thin air.
There is a big difference between money being "created" overall in the economy vs any individual bank or credit union's balance sheet.
Unless I am missing something, when a bank or credit union makes a loan - the balance sheet (assets and liabilities) bottom line stays the same.
The terminology is a little confusing. When a loan is made, assets and liabilities increase by the same amount. Capital has not changed. But the borrowers checking account (or the guy he paid the loan proceeds to) has a corresponding larger balance; the money supply has increased. Capital is not money, it is the excess of assets over liabilities.
As I recall Paul Samuelson Econ 101 - so many decades ago - banks indivudually do not create money - the system does.

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Oicuryy
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Re: How banks create money, not from deposits

Post by Oicuryy » Sat Mar 10, 2018 7:13 pm

This guy claims to have settled the question of whether or not individual banks can create money out of thin air.
https://www.sciencedirect.com/science/a ... 1914001070

Ron
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Re: How banks create money, not from deposits

Post by cjking » Sun Mar 11, 2018 5:15 am

That paper seems to be both a serious academic publication, and (to me at least) rather funny. (Did we, in 2014, really not know how money was created? And did we have to conduct a physical experiment inside a bank to find out?)

Summary, he reviews three different theories of how money is created, then goes into a bank and takes out a loan, tracing all bank activity that results from his transaction, proving which of the theories is correct. The abstract is quoted below.
This paper presents the first empirical evidence in the history of banking on the question of whether banks can create money out of nothing. The banking crisis has revived interest in this issue, but it had remained unsettled. Three hypotheses are recognised in the literature. According to the financial intermediation theory of banking, banks are merely intermediaries like other non-bank financial institutions, collecting deposits that are then lent out. According to the fractional reserve theory of banking, individual banks are mere financial intermediaries that cannot create money, but collectively they end up creating money through systemic interaction. A third theory maintains that each individual bank has the power to create money ‘out of nothing’ and does so when it extends credit (the credit creation theory of banking). The question which of the theories is correct has far-reaching implications for research and policy. Surprisingly, despite the longstanding controversy, until now no empirical study has tested the theories. This is the contribution of the present paper. An empirical test is conducted, whereby money is borrowed from a cooperating bank, while its internal records are being monitored, to establish whether in the process of making the loan available to the borrower, the bank transfers these funds from other accounts within or outside the bank, or whether they are newly created. This study establishes for the first time empirically that banks individually create money out of nothing. The money supply is created as ‘fairy dust’ produced by the banks individually, "out of thin air".

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Re: How banks create money, not from deposits

Post by cjking » Sun Mar 11, 2018 5:26 am

dm200 wrote:
Sat Mar 10, 2018 2:58 pm
As I recall Paul Samuelson Econ 101 - so many decades ago - banks indivudually do not create money - the system does.
My interpretation is that this is the "fractional reserve" theory of how money is created. The paper linked subsequently says that was popular from the 1930's to the late 1960's, when it was replaced by the "financial intermediation" theory. However both of these are now claimed to be wrong, and the "credit creation" theory, which the paper says was popular in the first two decades of the 20th century, is concluded to be correct.

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Re: How banks create money, not from deposits

Post by S_Track » Sun Mar 11, 2018 7:44 am

cjking wrote:
Sun Mar 11, 2018 5:15 am
That paper seems to be both a serious academic publication, and (to me at least) rather funny. (Did we, in 2014, really not know how money was created? And did we have to conduct a physical experiment inside a bank to find out?)
Agreed, hard to beleive its such a mystery. Perhaps the process has eveloved over time as policy and regulations have changed? Bob

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Re: How banks create money, not from deposits

Post by S_Track » Sun Mar 11, 2018 7:49 am

If the credit creation theory of banking is true, what are the banks doing with all the deposited money they receive?

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Re: How banks create money, not from deposits

Post by welderwannabe » Sun Mar 11, 2018 8:05 am

bob_m10 wrote:
Sun Mar 11, 2018 7:49 am
If the credit creation theory of banking is true, what are the banks doing with all the deposited money they receive?
In addition to capital requirements, banks also have reserve requirements. They are required to hold a certain amount of deposits as 'vault cash' and/or on deposit with the Federal Reserve. The Fed pays interest on these reserves...which is relatively new. I believe the Fed paying interest on these ws instituted as part of the financial crisis reforms as an incentive for banks to keep more reserves. Current rate is 1.5%. So if you deposit money into your Ally savings account at 1.45%, they can turn around and deposit it at the Fed as excess reserves and get 1.50%, making a spread of 5 basis points.

The percentage of a given deposit that they most keep in the vault or deposited with the Fed depends on what type of deposit it was. Checking accounts have a higher required percentage, while CDs have the lowest. Basically the more cumbersome it is to get your money out of a given type of account, the less of the deposit the bank has to keep on hand.

So when making a loan both capital and reserve requirements need to be met. If you get a $50K loan and have the bank deposit the $50K into your checking account, then they just up your checking account by $50K basically out of thin air. However, if there was a 10% reserve requirement for checking accounts then they would need to make sure they have an extra $5K of vault cash, or an extra $5k on deposit with the Federal reserve to account for that extra $50K of money that they now have 'on deposit' as a result of your loan. If, on the other hand, you had the $50K deposited into a savings account then the reserve requirement would be lower. Lets say 5%. Now the bank only needs $2500 of vault cash. Lets say you open a CD with the $50K? Now maybe its a 1% reserve requirement, so the bank might only need $500 in vault cash to cover it. That is why banks prefer savings accounts over checking etc, and incent customers to use savings account by paying interest on them.

The above percentages I made up out of thin air just for example purposes, but this is my understanding on the process based on research and some of the courses I have taken. I am sure there are some on here from the banking industry who can provide more detail/corrections.
I am not an investment professional, but I did stay at a Holiday Inn Express last night.

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Re: How banks create money, not from deposits

Post by S_Track » Sun Mar 11, 2018 9:09 am

welderwannabe wrote:
Sun Mar 11, 2018 8:05 am
bob_m10 wrote:
Sun Mar 11, 2018 7:49 am
If the credit creation theory of banking is true, what are the banks doing with all the deposited money they receive?
In addition to capital requirements, banks also have reserve requirements. They are required to hold a certain amount of deposits as 'vault cash' and/or on deposit with the Federal Reserve. The Fed pays interest on these reserves...which is relatively new. I believe the Fed paying interest on these ws instituted as part of the financial crisis reforms as an incentive for banks to keep more reserves. Current rate is 1.5%. So if you deposit money into your Ally savings account at 1.45%, they can turn around and deposit it at the Fed as excess reserves and get 1.50%, making a spread of 5 basis points.

The percentage of a given deposit that they most keep in the vault or deposited with the Fed depends on what type of deposit it was. Checking accounts have a higher required percentage, while CDs have the lowest. Basically the more cumbersome it is to get your money out of a given type of account, the less of the deposit the bank has to keep on hand.

So when making a loan both capital and reserve requirements need to be met. If you get a $50K loan and have the bank deposit the $50K into your checking account, then they just up your checking account by $50K basically out of thin air. However, if there was a 10% reserve requirement for checking accounts then they would need to make sure they have an extra $5K of vault cash, or an extra $5k on deposit with the Federal reserve to account for that extra $50K of money that they now have 'on deposit' as a result of your loan. If, on the other hand, you had the $50K deposited into a savings account then the reserve requirement would be lower. Lets say 5%. Now the bank only needs $2500 of vault cash. Lets say you open a CD with the $50K? Now maybe its a 1% reserve requirement, so the bank might only need $500 in vault cash to cover it. That is why banks prefer savings accounts over checking etc, and incent customers to use savings account by paying interest on them.

The above percentages I made up out of thin air just for example purposes, but this is my understanding on the process based on research and some of the courses I have taken. I am sure there are some on here from the banking industry who can provide more detail/corrections.
Excellent explanation, thank you.

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Re: How banks create money, not from deposits

Post by bhsince87 » Sun Mar 11, 2018 11:40 am

Yes, that is how the banking system actually works today, in most of the developed world at least. There are minor differences between countries though. Canada and the UK both have ZERO reserve requirements!

The system didn't become fully floating in the US until the early 1970's, and it has taken a long time for the older theories to pass on.

This is the best book I've read on the topic, https://www.amazon.com/Pragmatic-Capita ... capitalism

The author also has a blog with the same name, and you can find many of the explanations there as well.
BH87

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Re: How banks create money, not from deposits

Post by bhsince87 » Sun Mar 11, 2018 11:43 am

I also just found this on wikipedia, and it's pretty good.

https://en.wikipedia.org/wiki/Reserve_r ... ted_States
BH87

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Re: How banks create money, not from deposits

Post by Agggm » Sun Mar 11, 2018 11:48 am

bob_m10 wrote:
Sat Mar 10, 2018 9:15 am
Hi All,

I found the article linked below where the author explained how money is created by commercial banks. It seems there has been a misconception for many years as to the process:

“While many people may think that banks take in savers’ money and then lend it out, this is a misconception. So too is the idea that money is created by the Bank of England.
Instead the Bank’s paper says that 97 per cent of broad money currently in circulation is made up of bank deposits, which it explains are essentially IOUs from commercial banks to households and companies. Banks create money by making new loans.
The money for your mortgage has not come from a pool of savers – it was created by a computer keystroke.”

Is this really how it works? If it is true, and commercial bank create deposits when they award a loan, it seems to me that loan defaults would not be too burdensome for the bank. Has the bank really lost any money if the loan is not paid back?

http://www.thisismoney.co.uk/money/comm ... s-cut.html

Thanks
This took me way back when I took my first econ class. That chapter on money supply was strange but cool.

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Re: How banks create money, not from deposits

Post by Chuck5781 » Sun Mar 11, 2018 12:19 pm

Banks are merely intermediaries between savers and borrowers. Deposits fund loans, period.

Most banks in your hometown will lend around 80-95% of the deposits they hold to borrowers; the remainder of deposits will be held in marketable bonds and other interest earning assets such as funds invested overnight with another bank.

A good performing bank will maintain a spread of 3.5 - 4% between what they pay for deposits, and what they charge borrowers.

As a general rule, a bank will maintain around 15-20% liquidity - meaning they could quickly respond to an outflow of that portion of their deposits, by selling their bonds and borrowing against a line of credit they maintain at another bank. This is regardless of whether any reserve requirement is in effect. Should a circumstance arise (in a crisis) that depositors demanded more than what a bank could deliver - that’s called a “run on the bank” - a liquidity crisis - and that’s when the FDIC would step in and provide liquidity to depositors. Thankfully, that’s not often.

Community banks typically hold 8.5 - 11% of their assets as a capital cushion - to absorb potential losses. The largest banks are allowed to hold as little as 5%. So shareholders and Boards of Directors have a good deal of skin in the game, and work diligently to avoid losses. Banks are highly regulated, create detailed balance sheets and income statement daily, and are required to submit their financial results quarterly to the FDIC. All banks are subject to onsite examinations by various state and federal agencies every 12-18 months. We have a very safe and sound financial system of banks and credit unions.

All of this is fascinating to those of us who invest in or run banks, but to the ordinary citizen, the most important thing to know is the FDIC insured limit - when we exceed that, we need to consider limiting our risk by using strategies to create accounts with different ownership titles, or spreading deposits to other financial institutions. In fact, most banks will help us do that if we just ask.
The richest man is not he who has the most, but he who needs the least.

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Oicuryy
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Re: How banks create money, not from deposits

Post by Oicuryy » Sun Mar 11, 2018 12:20 pm

bob_m10 wrote:
Sun Mar 11, 2018 7:49 am
If the credit creation theory of banking is true, what are the banks doing with all the deposited money they receive?
When you deposit money at a bank you are actually making a loan to the bank. The money you loan to the bank becomes an asset of the bank. In return the bank gives you an IOU promising to pay the money back. This IOU becomes a liability of the bank.

Typically banks use the money you lend them to buy assets that pay them a return.

A similar thing happens when you give the bank an IOU promising to pay them money in the future. That IOU becomes an asset of the bank. In return the bank gives you an IOU that you can redeem at any time.

Bank-written IOUs function as money. They are counted as part of the M2 money supply. When you deposit money at a bank you are exchanging money for money. But when you borrow from a bank you are exchanging an IOU for money. That is how banks can create money.

Ron
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Oicuryy
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Re: How banks create money, not from deposits

Post by Oicuryy » Sun Mar 11, 2018 1:31 pm

Here are direct links to the .pdf versions of the Bank of England articles referred to by the article linked to in the opening post.

Money in the modern economy: an introduction
https://www.bankofengland.co.uk/-/media ... .pdf?la=en

Money creation in the modern economy
https://www.bankofengland.co.uk/-/media ... .pdf?la=en

Here are links to the corresponding videos.
https://www.youtube.com/watch?v=ziTE32hiWdk
https://www.youtube.com/watch?v=CvRAqR2pAgw

Ron
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dual
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Re: How banks create money, not from deposits

Post by dual » Sun Mar 11, 2018 1:42 pm

For a good explanation of the creation of money by banks see Naked Money by Charles Wheelan. Wheelan is too easy on fiat money and too dismissive of asset backed currencies but if you take into account his bias his explanations are clear.

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Re: How banks create money, not from deposits

Post by cjking » Sun Mar 11, 2018 1:50 pm

Chuck5781 wrote:
Sun Mar 11, 2018 12:19 pm
Banks are merely intermediaries between savers and borrowers. Deposits fund loans, period.
Can you say why the statements to the contrary in the various links are wrong?

Wikipedia also appears to disagree with you.

https://en.wikipedia.org/wiki/Money_creation
Most of the money supply[who?] is in the form of bank deposits.[1][2] Bank loans increase the quantity of broad money to more than the amount of base money issued by the central bank. Governmental authorities, including central banks and other bank regulators, can use policies such as reserve requirements, and capital adequacy ratios to limit the amount of broad money created by commercial banks.
When a commercial bank loan is extended, new commercial bank money is created if the loan proceeds are issued in the form of an increase in a customer's demand deposit account (that is, an increase in the bank's demand deposit liability owed to the customer).[citation needed] As a loan is paid back through reductions in the demand deposit liabilities the bank owes to a customer, that commercial bank money disappears from existence. Because loans are continually being issued in a normally functioning economy, the amount of broad money in the economy remains relatively stable. Because of this money creation process by the commercial banks, the money supply of a country is usually a multiple larger than the money issued by the central bank; that multiple was traditionally determined by the reserve requirements and now essentially by other financial ratios (primarily the capital adequacy ratio that limits the overall credit creation of a bank) set by the relevant banking regulators in the jurisdiction.[citation needed]

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Re: How banks create money, not from deposits

Post by S_Track » Mon Mar 12, 2018 6:08 pm

It seems the credit creation theory of banking is true, but is it really all the different from the earlier theories? What is the difference if the Bank creates the credit or if the central banks creates the money and passes it down.

If banks can create credit, then why is the interest rate the fed sets makes much of a difference?

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Re: How banks create money, not from deposits

Post by Phineas J. Whoopee » Mon Mar 12, 2018 7:20 pm

S_Track wrote:
Mon Mar 12, 2018 6:08 pm
It seems the credit creation theory of banking is true, but is it really all the different from the earlier theories? What is the difference if the Bank creates the credit or if the central banks creates the money and passes it down.

If banks can create credit, then why is the interest rate the fed sets makes much of a difference?
I am not arguing with most prior posters. Please permit me to give my explanation, the way I explain it.

When a customer deposits money into a bank (or other licensed depository institution, like a credit union), legally the money becomes the bank's property. They own the deposit, and owe the depositor and must pay them back based on the type of deposit and contract. I believe that's where the confusing IOU terminology comes from.

A bank deposit is much different from an investment through a broker. The broker does not own the assets, and does not owe them either. They are held by a third party. Depositing money into a savings account and buying a money market mutual fund may seem similar, but the underlying setup is not the same.

For the rest of this post I will discuss the US banking system, because it is the only one I know well.

US banks are required by law to keep a certain percentage of deposited money on hand, to meet withdrawal requests. It's more complicated but close enough to say that it's about 10% of consumer checking deposits, also called demand deposits. Other deposits, including business checking, are not included, but of course a responsible bank will exercise reasonable prudence.

The amount kept is called Bank Reserves, and can be held in two forms, both of which have to add up to at least the approximately 10%. One form is physical cash in their physical vault. The other form is deposits held at their regional Federal Reserve Bank.

It is true, and a lot of people don't like it when they first learn it, that when a bank issues a loan it creates two things simultaneously: a bank deposit for the borrower; and a debt from the borrower. The two are equal in amount, so net financial assets across the economy have not changed. The money is newly created, but so is the debt.

As the borrower pays back principal, not interest, the newly-created money is destroyed along with the debt.

Default by the borrower resulting in the lender writing off the loan also destroys money. The total amount is always in balance. Net financial assets across the economy are unchanged.

Interest, in a macroeconomic sense, can be paid because of economic production.

Let's take a little time out. Money, as presently understood in mainstream economics, has three distinct functions, but they're all related. They are:

A medium of exchange. If my employer pays me money today for my labor I can take it to the grocery store and buy a couple of raw chickens, some potatoes, and some carrots. It isn't necessary for me to work for the grocery store directly to acquire those.

A store of value. If my employer pays me today for my labor I can take it to the grocery store a couple of days from now and procure the same food. Some people at this point ask what happens if there's hyperinflation, normally taken to mean at least 50% per month. Extreme conditions always create difficulties. Nothing in the real world is perfect.

A unit of account. If I invite you over to admire my spiffy new $500 bicycle, what do you expect to see? Five $100 bills? No. It is the bicycle and its market value we're admiring.

The fourth, a standard of deferred payment, in modern economics has been subsumed into the others.

Now, back to our usual programming.

Banks are required to close their business day with enough reserves. If they don't, they're in big trouble, and will fail. To avoid a systemic problem, banks which happen to end the day with excess reserves lend it, at interest, to those which happened to close with not enough. The Federal Reserve System, via the Federal Open Market Committee, FOMC, sets a target rate at which banks will lend excess reserves to each other overnight, which includes over-weekend. Banks with higher risk of default have to pay more interest. It's called the Federal Funds Rate, FFR. The Fed neither lends nor borrows at the FFR. It's just that excess reserves on deposit with regional Fed banks are called Federal Funds.

Should a bank not be able to secure a loan to raise its required reserves, it can turn directly to the Fed for help, via the Discount Window. That's the Fed acting in its capacity as lender of last resort. The Fed sets the Discount Rate, which is higher than the FFR. Banks less likely to pay the loan back are charged more interest. Borrowing from the discount window is confidential, because its whole point is to prevent bank runs, and if anybody knew a bank had to resort to it a run would result.

During last decade's financial crisis the Fed cajoled sound banks to take discount window loans to erase the stigma, thereby preventing the problem from feeding on itself and becoming still worse.

To sum up: Banks are limited in their lending by their reserves. Across the economy as a whole, as opposed to any individual bank in particular, the total amount of lendable money is constrained by total banking reserves. When the Fed changes the Federal Funds Rate, its main policy rate, it affects what less sound banks can reasonably borrow from more sound ones. When it engages in Open Market Operations, the mechanism it uses to manage the FFR, it changes overall bank reserves and therefore the total amount of money available to be lent.

Does that help?

PJW
Last edited by Phineas J. Whoopee on Mon Mar 12, 2018 9:22 pm, edited 1 time in total.

S_Track
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Re: How banks create money, not from deposits

Post by S_Track » Mon Mar 12, 2018 8:23 pm

Phineas J. Whoopee wrote:
Mon Mar 12, 2018 7:20 pm
S_Track wrote:
Mon Mar 12, 2018 6:08 pm
It seems the credit creation theory of banking is true, but is it really all the different from the earlier theories? What is the difference if the Bank creates the credit or if the central banks creates the money and passes it down.

If banks can create credit, then why is the interest rate the fed sets makes much of a difference?
The amount kept is called Bank Reserves, and can be held in two forms, both of which have to add up to at least the approximately 10%. One form is physical cash in their physical vault. The other form is deposits held at their regional Federal Reserve Bank.
If the banks hold money at the regional federal reserve bank, does it earn interest? Thanks for putting this together with the included links, Very helpful.

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Re: How banks create money, not from deposits

Post by Phineas J. Whoopee » Mon Mar 12, 2018 9:09 pm

S_Track wrote:
Mon Mar 12, 2018 8:23 pm
...
If the banks hold money at the regional federal reserve bank, does it earn interest? Thanks for putting this together with the included links, Very helpful.
At present yes. In the US there's one rate for required reserves, and another for excess reserves, but so far they always have been the same. There's no legally-mandated equivalence. It's a monetary policy decision. They're both 1.5% at present.

Some central banks outside the US have negative interest on excess reserves, to encourage bank lending. That's what's led to so many scare stories. Although it could conceivably happen, it doesn't necessarily mean consumer savings accounts have to be debited in nominal terms.

PJW

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Re: How banks create money, not from deposits

Post by OnTrack » Mon Mar 12, 2018 9:54 pm

For an easier to understand explanation of the banking system:
https://ia600307.us.archive.org/10/item ... ederal.pdf
See page 9 of the above regarding money creation. The above was published in 2008, so some details may be a little out of date.

The following was published in 2017, looks like they are updating the series.
https://www.newyorkfed.org/medialibrary ... lColor.pdf

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Re: How banks create money, not from deposits

Post by boglerdude » Tue Mar 13, 2018 5:36 am

What happens if the Fed stops paying interest on reserves. The banks will make more loans...without increasing credit risk?

If they increase risk, why not increase capital requirements, instead of paying banks not to lend. Put their skin in the game.

Can banks buy stocks or bonds with excess reserves?

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Re: How banks create money, not from deposits

Post by cjking » Tue Mar 13, 2018 7:09 am

Just a side-note, I remembered a comment somewhere that not all central banks require commercial banks to hold reserves, so I googled the following.

https://en.wikipedia.org/wiki/Reserve_requirement
Canada, the UK, New Zealand, Australia, Sweden and Hong Kong[11] have no reserve requirements.

This does not mean that banks can—even in theory—create money without limit. On the contrary, banks are constrained by capital requirements, which are arguably more important than reserve requirements even in countries that have reserve requirements.

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Re: How banks create money, not from deposits

Post by feh » Tue Mar 13, 2018 11:41 am

S_Track wrote:
Sat Mar 10, 2018 9:15 am

Is this really how it works?
You may find this illuminating:

https://www.youtube.com/watch?v=PHe0bXAIuk0

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Phineas J. Whoopee
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Re: How banks create money, not from deposits

Post by Phineas J. Whoopee » Tue Mar 13, 2018 12:14 pm

boglerdude wrote:
Tue Mar 13, 2018 5:36 am
What happens if the Fed stops paying interest on reserves. The banks will make more loans...without increasing credit risk?

If they increase risk, why not increase capital requirements, instead of paying banks not to lend. Put their skin in the game.

Can banks buy stocks or bonds with excess reserves?
With respect to required reserves it will make no difference. For excess reserves there would be more reason for banks to lend, which increases systemic required vs. excess reserves, although of course they make each decision individually based on many more facts than monetary policy. The larger the loan the greater the attention. That said, the US banking system as a whole, not each and every individual bank, is swimming in excess reserves at present.

In case anybody wants to go on to the next logical question, the Fed normally makes a lot of profit, because all of its costs, including the legally-mandated 8% dividend to member banks, are far less than the interest it receives on the securities it buys in the secondary market. The practice is for the Fed to donate all the profits to the US Treasury, but that is not ensconced in law.

The Fed only was granted, by act of congress, legal authority to pay interest on reserves in 2008. Then FOMC chair Ben Bernake asked for it as an additional tool with which to address the then-unfolding financial crisis.

Regulations on how much and what banks can invest in for their own accounts, as opposed to following their customers' orders for their accounts, have been in flux. It became much more complicated with the 1999 repeal of the Glass-Steagall Act, also called the Banking Act of 1933.

Anything a bank takes out from its excess reserves is no longer any type of reserves.

PJW

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Re: How banks create money, not from deposits

Post by Ben Mathew » Tue Mar 13, 2018 2:49 pm

This article is talking about how our modern fractional reserve banking system creates money by lending. This is not a new idea in economics. It's pretty standard fare in Econ 101. It was covered in the Econ 101 course I took as an undergrad in the 1990s. And it was covered in the Econ 101 course I taught in the 2000s. I'm not aware of widespread misconception--it's just a cool idea that surprises people when they first encounter it (I certainly found it very interesting).

For those who are not clear on how our fractional reserve banking system creates money, but don't want to thumb through an econ 101 text, here's a summary:

To understand fractional banks, it's useful to contrast it to a simpler warehouse bank. A warehouse bank is just a secure building where you store your cash. If Jim deposits $100 in the bank, all of that money is stored safely in the bank's vaults. The bank's balance sheet looks like this:

ASSETS: $100 in the vault (reserves)
LIABILITIES: $100 owed to Jim (deposits)

A fractional reserve bank, by contrast, keeps only a fraction of its deposits (say 20%) in the vault to cover withdrawals, and loans out the rest. So it keeps 20% ($20 ) of Jim's deposit in the vault, and loans out the remaining 80% ($80) to Meg. The 20% it keeps to cover withdrawals is called the reserve ratio. So the bank's balance sheet looks like this:

ASSETS: $20 in the vault (reserves) + $80 loan to Meg (loans)
LIABILITIES: $100 owed to Jim (deposits)

This just created more money in the economy. Why? Because Jim still has $100 in his checking account, and Meg now has $80 in cash. That's a $180 total, up from $100 before. The fact that Meg's $80 can ultimately be traced to Jim's $100 checking account does not matter.

The story is not over. Now Meg proceeds to deposit her $80 in a bank somewhere. That bank will lend out another 80%*$80=$64 to someone else. That's another $64 of new money created. That person deposits that money in another bank, and that bank lends out 80%*$64=$51.20. And so on. After this cycle of lending and depositing eventually ends, the total money created would equal 1/reserve ratio = 1/.2 = 5 times the original deposit. So Jim's original $100 deposit in one bank will become $500 of deposits spread across the banking system. That's $400 of new money created.

Two things to note:

- The fractional banking system relies on the fact that it's unlikely that all depositors would want to withdraw all of their money from the bank at the same time. If that does happen, the bank would fail. The modern financial system uses deposit insurance and central bank lending to prevent this from happening.

- We normally use the terms "money" and "wealth" interchangeably. But technically, they are very different. Money refers to the amount of liquid assets we can use to facilitate transactions. Lending by fractional reserve banks creates money in the form of liquid checking accounts, but it does not create wealth. Every loan creates an asset and a balancing liability for all parties involved--the bank as well as the borrower.

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Re: How banks create money, not from deposits

Post by bhsince87 » Tue Mar 13, 2018 6:06 pm

Ben Mathew wrote:
Tue Mar 13, 2018 2:49 pm
This article is talking about how our modern fractional reserve banking system creates money by lending. This is not a new idea in economics. It's pretty standard fare in Econ 101. It was covered in the Econ 101 course I took as an undergrad in the 1990s. And it was covered in the Econ 101 course I taught in the 2000s. I'm not aware of widespread misconception--it's just a cool idea that surprises people when they first encounter it (I certainly found it very interesting).

For those who are not clear on how our fractional reserve banking system creates money, but don't want to thumb through an econ 101 text, here's a summary:

To understand fractional banks, it's useful to contrast it to a simpler warehouse bank. A warehouse bank is just a secure building where you store your cash. If Jim deposits $100 in the bank, all of that money is stored safely in the bank's vaults. The bank's balance sheet looks like this:

ASSETS: $100 in the vault (reserves)
LIABILITIES: $100 owed to Jim (deposits)

A fractional reserve bank, by contrast, keeps only a fraction of its deposits (say 20%) in the vault to cover withdrawals, and loans out the rest. So it keeps 20% ($20 ) of Jim's deposit in the vault, and loans out the remaining 80% ($80) to Meg. The 20% it keeps to cover withdrawals is called the reserve ratio. So the bank's balance sheet looks like this:

ASSETS: $20 in the vault (reserves) + $80 loan to Meg (loans)
LIABILITIES: $100 owed to Jim (deposits)

This just created more money in the economy. Why? Because Jim still has $100 in his checking account, and Meg now has $80 in cash. That's a $180 total, up from $100 before. The fact that Meg's $80 can ultimately be traced to Jim's $100 checking account does not matter.

The story is not over. Now Meg proceeds to deposit her $80 in a bank somewhere. That bank will lend out another 80%*$80=$64 to someone else. That's another $64 of new money created. That person deposits that money in another bank, and that bank lends out 80%*$64=$51.20. And so on. After this cycle of lending and depositing eventually ends, the total money created would equal 1/reserve ratio = 1/.2 = 5 times the original deposit. So Jim's original $100 deposit in one bank will become $500 of deposits spread across the banking system. That's $400 of new money created.

Two things to note:

- The fractional banking system relies on the fact that it's unlikely that all depositors would want to withdraw all of their money from the bank at the same time. If that does happen, the bank would fail. The modern financial system uses deposit insurance and central bank lending to prevent this from happening.

- We normally use the terms "money" and "wealth" interchangeably. But technically, they are very different. Money refers to the amount of liquid assets we can use to facilitate transactions. Lending by fractional reserve banks creates money in the form of liquid checking accounts, but it does not create wealth. Every loan creates an asset and a balancing liability for all parties involved--the bank as well as the borrower.
This is close, and is the way things used to operate. But it's not 100% acurate any more in many countries.

In some cases, banks don't need reserves or deposits to make a loan. They can just decide to make one if they think it makes business sense for them. Capital levels come into play here, but reserves don't necessarily.

Afterward, if they need to meet a reserve requirement at the end of the day, they can borrow reserves from other banks in the interbank system. But as noted above, in some countries they don't even need to do that anymore!
BH87

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Re: How banks create money, not from deposits

Post by alex_686 » Tue Mar 13, 2018 6:56 pm

bhsince87 wrote:
Tue Mar 13, 2018 6:06 pm
In some cases, banks don't need reserves or deposits to make a loan. They can just decide to make one if they think it makes business sense for them. Capital levels come into play here, but reserves don't necessarily.
It can be even more invidious than that. Anything that acts like money - liquid, stable value - is money. Until it is not. Treasury notes, commercial paper, etc. are normally considered cash. Hence money market funds and repos are also considered cash. Conventional conforming mortgages that can be deposited at the Fed can be turned into cash overnight. Expect in 2008 when the market froze. Then they weren't.

Money is a social construct. It can change. I would recommend the book: Money: The Unauthorised Biography by Felix Martin

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Re: How banks create money, not from deposits

Post by OnTrack » Tue Mar 13, 2018 9:20 pm

From article about how the U.S. Fed bought $1.25 trillion of mortgages in 15 months.
https://www.npr.org/sections/money/2010 ... 5-trillion
'The Fed was able to spend so much money so quickly because it has a unique power: It can create money out of thin air, whenever it decides to do so. So, Dzina explains, the mortgage team would decide to buy a bond, they’d push a button on the computer — "and voila, money is created."'

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Re: How banks create money, not from deposits

Post by Oicuryy » Tue Mar 13, 2018 9:46 pm

OnTrack wrote:
Tue Mar 13, 2018 9:20 pm
From article about how the U.S. Fed bought $1.25 trillion of mortgages in 15 months.
https://www.npr.org/sections/money/2010 ... 5-trillion
'The Fed was able to spend so much money so quickly because it has a unique power: It can create money out of thin air, whenever it decides to do so. So, Dzina explains, the mortgage team would decide to buy a bond, they’d push a button on the computer — "and voila, money is created."'
And the point of this thread is that banks can do the same thing. They decide to make a loan, they push a button on the computer and voila money is created.

Ron
Money is fungible | Abbreviations and Acronyms

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Re: How banks create money, not from deposits

Post by S_Track » Wed Mar 14, 2018 3:51 am

bhsince87 wrote:
Tue Mar 13, 2018 6:06 pm

This is close, and is the way things used to operate. But it's not 100% acurate any more in many countries.

In some cases, banks don't need reserves or deposits to make a loan. They can just decide to make one if they think it makes business sense for them. Capital levels come into play here, but reserves don't necessarily.

Afterward, if they need to meet a reserve requirement at the end of the day, they can borrow reserves from other banks in the interbank system. But as noted above, in some countries they don't even need to do that anymore!
Would you please explain exactly what is meant by capital levels. Does it include the banks current reserves?

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Re: How banks create money, not from deposits

Post by cjking » Wed Mar 14, 2018 7:36 am

I wondered what google had to say about that. I don't know if this page I found helps.

https://bizfluent.com/facts-5723394-res ... ments.html
Reserve Requirements
Depository institutions, such as banks and credit unions, must hold reserves in the form of cash in their own vaults or deposits with Federal Reserve, which pays interest on the deposit. The requirement is a ratio, typically 3 percent or 10 percent of total deposits, depending on the size of the bank. For example, if the total deposits for all customers is $100 million in deposits and the ratio is 10 percent, the bank must hold $10 million in cash in its vaults at all times.

Capital Requirements
A bank's assets are its loans or other lines of credit to customers. Capital requirements ensure that banks have enough capital to support these loans. The capital also must meet regulated ratios of equity vs. debt (such as bonds). In 2014, federal regulators directed the eight largest U.S. banks to add nearly $70 billion in extra capital so they are better positioned to cover losses incurred in market downturns.
(That didn't entirely make things clear to me. My theory is that "reserves" are there to ensure you can meet demands for withdrawals, they prevent liquidity problems. "Reserves" could be borrowed. Spare "capital" is your own money that is there to ensure you don't go bust, capital is eliminated when you write off loans. )

(In "It's a Wonderful Life", during a run on the bank, the manager has to explain that someone can't withdraw their money because it is tied up in someone else's mortgage The bank's not bust, it just doesn't have any cash right now for people who want to withdraw. Reserves would have prevented that problem. On the other hand, if enough people like aforementioned home-owner went bust without repaying their loans, the bank would be bust, and would never be able to repay depositors. Capital requirements might have prevented that, bank owners rather than bank customers would have taken the loss from the bad loans. (Even if I've remembered the movie wrong, I suppose my version is still useful as an explanation.))

(I'm sure someone who isn't relying on old movies for their economic knowledge will be along shortly to give a better explanation.)

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Re: How banks create money, not from deposits

Post by dm200 » Wed Mar 14, 2018 9:16 am

cjking wrote:
Wed Mar 14, 2018 7:36 am
I wondered what google had to say about that. I don't know if this page I found helps.
https://bizfluent.com/facts-5723394-res ... ments.html
Reserve Requirements
Depository institutions, such as banks and credit unions, must hold reserves in the form of cash in their own vaults or deposits with Federal Reserve, which pays interest on the deposit. The requirement is a ratio, typically 3 percent or 10 percent of total deposits, depending on the size of the bank. For example, if the total deposits for all customers is $100 million in deposits and the ratio is 10 percent, the bank must hold $10 million in cash in its vaults at all times.
Capital Requirements
A bank's assets are its loans or other lines of credit to customers. Capital requirements ensure that banks have enough capital to support these loans. The capital also must meet regulated ratios of equity vs. debt (such as bonds). In 2014, federal regulators directed the eight largest U.S. banks to add nearly $70 billion in extra capital so they are better positioned to cover losses incurred in market downturns.
(That didn't entirely make things clear to me. My theory is that "reserves" are there to ensure you can meet demands for withdrawals, they prevent liquidity problems. "Reserves" could be borrowed. Spare "capital" is your own money that is there to ensure you don't go bust, capital is eliminated when you write off loans. )
(In "It's a Wonderful Life", during a run on the bank, the manager has to explain that someone can't withdraw their money because it is tied up in someone else's mortgage The bank's not bust, it just doesn't have any cash right now for people who want to withdraw. Reserves would have prevented that problem. On the other hand, if enough people like aforementioned home-owner went bust without repaying their loans, the bank would be bust, and would never be able to repay depositors. Capital requirements might have prevented that, bank owners rather than bank customers would have taken the loss from the bad loans. (Even if I've remembered the movie wrong, I suppose my version is still useful as an explanation.))
(I'm sure someone who isn't relying on old movies for their economic knowledge will be along shortly to give a better explanation.)
Not necessarily.

No bank or credit union (by itself) can, with 100% certainty, survive a "run" of withdrawals. It would need backing of lines of credit, perhaps some slight (but within the law/regs) delays of such withdrawals, etc. to survive such a run. Such "runs" are, fortunately, rare these days. I believe that Indymac was a notable case where folks lined up to take money out - and it eventually folded.

I also doubt this is correct:
For example, if the total deposits for all customers is $100 million in deposits and the ratio is 10 percent, the bank must hold $10 million in cash in its vaults at all times.


Smaller credit unions may not have to keep reserves at all (or at least in significant amounts), although they must keep adequate liquidity (regulatory) and "net worth" percentages. Such smaller credit unions will also reduce such risk by various lines of credit from Corporate credit unions and/or other financial institutions.

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Re: How banks create money, not from deposits

Post by Oicuryy » Wed Mar 14, 2018 9:47 am

Wikipedia has a general description of the Capital Adequacy Ratio.
https://en.wikipedia.org/wiki/Capital_adequacy_ratio

Details for FDIC-insured banks are in 12 CFR 324.
https://www.fdic.gov/regulations/laws/r ... -4350.html

Reserve balances held at Federal Reserve banks have a weight of zero in the calculation of risk-weighted assets. Could that be why the money supply has not increased as much as the fractional reserve theory predicts?

Ron
Money is fungible | Abbreviations and Acronyms

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Re: How banks create money, not from deposits

Post by alex_686 » Wed Mar 14, 2018 10:06 am

Oicuryy wrote:
Wed Mar 14, 2018 9:47 am
Reserve balances held at Federal Reserve banks have a weight of zero in the calculation of risk-weighted assets. Could that be why the money supply has not increased as much as the fractional reserve theory predicts?
The fractional reserve theory does not hold much weight today. Same for M1, M2, etc. Most of the money - lets say 90% - is created outside of that system.

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Re: How banks create money, not from deposits

Post by wrongfunds » Wed Mar 14, 2018 10:13 am

Except PJW's explanation, there is so much confusion between "money" and shiny currency! At least in US, there is single currency but in UK I think they have both English and Scottish currency.

Your local bank certainly has no ability to create new "currency" (aka cash). As digital world takes over, the total cash must be dwindling down in the system. All your million dollar portfolios are nothing but some ones and zeros in some remote database! Creation of new currency supply is controlled by different entity. Does it also control the creation of new "money" aka QE?

Can somebody explain how all of these cogs work in functioning economy?

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