4. How can banks create money out of thin air?

“Governments are willing to provide these backstops because banks run the payments system and create money — essential bits of infrastructure in any society that’s progressed beyond hunter-gathering.”

Banks can give you a loan to buy a car for let’s say 10.000$, without having 10.000$! Actually with only having 1.000$. How? 

 

We all know how banks make their money. They take either their own money but most of the time money from their clients and lend it to someone that wants to buy for example a car. The person that lends money pays interest and that is how banks make money. That is not the whole story! Banks do not only use the money they got from their clients, they make money by expanding their balance sheet. What does that mean? I have 500$ in my bank account and my friend has 2000 $ in his bank account. So the bank has 2500 $ in cash in its safe and 2500$ in deposit accounts.

Now the bank is allowed to give away loans for 25000$ because it needs to keep around 10% as a reserve, in case my friend decides to throw a party and needs 1000$ this Friday. On the one hand, the bank needs to make sure that they can always pay out their customers otherwise we would not trust this bank.  On the other hand, we do not throw a party every day so we do not need our money all the time. (Furthermore, the bank has thousands of customers and most of them leave their money in their bank accounts most of the time.) He needs 1000$ to throw the party and the bank is willing to lend me that amount. They transfer 100$ to her deposit account. Now the balance sheet of the bank will be longer? Why? They gave out a loan and created a deposit out of thin air.

From now on the bank has 3500$ on their balance sheet instead of 2500$ but they did not get more cash. They did not print money or anything, they just changed the numbers in the deposit accounts. So imagine that I want to take out my 500$ and my friend wants to take out her 3500$ (loan+deposits) out in cash as well. The bank would be screwed or illiquid because he does not have 3500$ in (paper) currency. So the bank would need to borrow money from another bank or the central bank. And this can go on and on. The banks can give a lot of people loans and expand their balance sheet, as long as they stay within certain regulations. The can give away loans and only need to have around 10 percent as reserves. 

Financial Times Quote: The quote says that banks are “creating” money and that is how they do it and why central banks are there to protect this system especially in a crisis. The need to lend money to banks, when banks can not pay their customer, even if they are solvent they are not liquid and don't always have enough currency, because they give away so many long term loans.

(Book recommendation: One Trillion Dollar by Andreas Eschbach)

Introduction

The first article: The hierarchy of money

The second article: Why do we need banks?

The third article: Why we need a central bank?

 

The fifth article: Why do we need central banks especially in a crisis?

The sixth article: What are clearing houses?

The seventh article: What are Fed Funds?

The eighth article: What are dealers, brokers and repos?

The ninth article: Quantitative easing and open market operation

The tenth article: Eurodollars

The eleventh article: Discounts, Discounts, Discounts

The twelfth article:  Why dealers provide liquidity

The thirteenth article: Rates and the Treynor Model

The fourteenth article: Brexit

Written by: Philine Paschen

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