Why banks don’t need your money to make loans
Traditional introductory economic textbooks generally treat banks as financial intermediaries, whose role is to connect borrowers with savers, facilitating their interactions by acting as credible intermediaries.
Individuals who earn more income than their immediate consumption needs can deposit their unused income in a reputable bank, thereby creating a pool of funds. The bank can then tap into these funds to lend to those whose incomes are below their immediate consumption needs. Read on to see how banks are actually using your deposits to make loans and how much they need your money to do so.
Key points to remember
- Banks are seen as financial intermediaries that connect savers and borrowers.
- However, banks actually rely on a fractional reserve banking system whereby banks can lend more than the number of actual deposits available.
- This leads to a monetary multiplier effect. If, for example, the amount of reserves held by a bank is 10%, then loans can multiply the money up to 10 times.
How it works
According to the above representation, a bank’s lending capacity is limited by the size of its customers’ deposits. To lend more, a bank must secure new deposits by attracting more customers. Without deposits, there would be no loans, that is, deposits create loans.
Of course, this history of bank lending is generally supplemented by the theory of the monetary multiplier which is consistent with what is called fractional reserve bank.
In a fractional reserve system, only a fraction of a bank’s deposits should be held in cash or in the deposit account of a commercial bank in the central bank. The magnitude of this fraction is specified by the reserve required, the reciprocal of which indicates the multiple of reserves that banks are able to lend. If the reserve requirements are 10% (i.e. 0.1) then the multiplier is 10, which means that banks can lend 10 times more than their reserves.
Bank lending capacity is not entirely limited by the ability of banks to attract new deposits, but by the capacity of the central bank Monetary Policy decisions whether or not to increase reserves. However, given a particular monetary policy regime and unless there is an increase in reserves, the only way for commercial banks to increase their lending capacity is to secure new deposits. Again, deposits create loans and therefore banks need your money to make new loans.
In March 2020, the Board of Governors of the Federal Reserve System reduced the minimum reserve ratios to 0%, effectively eliminating them for all deposit-taking institutions.
Banks in the real world
In today’s modern economy, most money takes the form of deposits, but rather than being created by a group of savers trusting the bank to withhold their money, deposits are actually created when banks extend loans (i.e. create new loans). As Joseph Schumpeter once wrote: “It is much more realistic to say that banks ‘create credit’, that is to say they create deposits in their loan deed than to say that they lend the deposits that have been entrusted to them.
When a bank grants a loan, two corresponding entries are entered on its balance sheet, one as an asset and the other as a liability. The loan counts as an asset for the bank and it is simultaneously cleared by a newly created deposit, which is a liability of the bank to the titular depositor. Contrary to the story described above, loans actually create deposits.
However, this may seem a little shocking since, while loans create deposits, private banks create money. But you might be wondering, “Isn’t the creation of money the only right and the only responsibility of central banks?” Well, if you think that reserve requirements are a binding constraint on the ability of banks to lend, then yes, in a way, banks cannot create money without the central bank easing the restrictions. reserve requirements or increases the number of reserves in the banking system.
The truth, however, is that the reserve requirement does not act as a binding constraint on the ability of banks to lend and, therefore, their ability to create money. The reality is that banks first grant loans and then seek out the necessary reserves.
Fractional reserve banking is effective, but it can also fail. During “bank race“, depositors all suddenly claim their money, which exceeds the amount of available reserves, which can lead to potential bankruptcy.
What really affects the ability of banks to lend
So if bank lending is not constrained by reserve requirements, are banks facing any constraint? There are two kinds of answers to this question, but they are related. The first answer is that banks are constrained by considerations of profitability; that is, given a certain demand for loans, banks base their lending decisions on their perception of risk-return trade-offs, not on reserve requirements.
The mention of risk brings us to the second, albeit related, answer to our question. In an environment where deposit accounts are insured by the federal government, banks may be tempted to take excessive risks in their lending transactions. Since the government insures deposit accounts, it is in the government’s interest to curb excessive risk-taking by banks. For this reason, the regulations capital requirements were put in place to ensure that banks maintain a certain ratio of capital to existing assets.
If bank lending is limited by anything, it is capital requirements, not reserve requirements. However, since capital requirements are specified as a ratio whose denominator consists of risk-weighted assets (RWA), they depend on how risk is measured, which in turn depends on how risk is measured. turn depends on subjective human judgment.
Subjective judgment combined with an ever-increasing thirst for profit can lead some banks to underestimate the risk of their assets. Thus, even with regulatory capital requirements, there remains a great deal of flexibility in the constraint imposed on banks’ ability to lend.
The bottom line
Profitability expectations therefore remain one of the main constraints weighing on the capacity, or better still, the willingness of banks to lend. And it is for this reason that even if the banks do need your money they do want to your money. As noted above, banks lend first and seek reserves later, but they to do look for reserves.
Attracting new customers is one way, if not the cheapest, to secure these reserves. This is because the current target federal funds rate, the rate at which banks borrow from each other, is 0% to 0.25% as of June 16, 2021, well above the interest rate of 0.01%. that the Bank of America pays into a standard savings account. Banks don’t need your money; it’s just cheaper for them to borrow from you than to borrow from other banks.