How banks make money

Many economic textbooks and popular YouTube movies teach an outdated theory about how banks create money. This post covers what is wrong with it,

The outdated money theory is known as the money multiplier theory and it is closely related to the idea of fractional reserve banking. While this theory was popular for many decades, top economists and central banks have since moved on to a new understanding of how banks create money. It is time that the rest of us do the same.

The mythical money multiplier theory goes like this: commercial banks are able to create money thanks to something called fractional reserve banking. Fractional reserve banking means that every bank has to hold only a fraction –hence the name– of the money they receive from people in reserve at the central bank. The rest of it, banks are free to lend out to other people. These people will, then, deposit that money at another bank. That bank also has to hold a fraction at the central bank but can lend out the rest. And, so the process repeats itself until there is no more money left to be lend out. Following the logic of this story, banks can only create a multiple of the original cash supply.

I do understand that this story sounds compelling. Yes, it is a bit abstract but it has a certain logic to it. The problem with this story is that researchers that work with banks and money directly have produced compelling work that has disproved the money multiplier myth. As a consequence, top economists and central bankers have long moved on and are no longer using it.

Sadly, educational textbooks and videos often lag a bit behind developments in economic research. Hence, this story is still being told in multiple prominent textbooks. And even in some very popular YouTube videos.

So, what is the real story, that is being rolled out by state of the art textbooks such as the new, and free, CORE economics textbook that was produced by leading economists in the UK? This is also the story that has been largely adopted by the central banking world.

On one thing the money multiplier myth is correct. Banks do indeed create money when they give out loans. But in real life it is actually much more simple than the money multiplier process. So, how DOES that work? Well, a customer goes to a bank to request a loan. When the bank approves it, two things will be recorded. The first is that the customer owes the bank a certain amount of money, due to be payed back at a certain time and at a certain interest rate. The second, is that the bank owes its customer the same exact amount of money, on demand.

Yes that is right, a customer borrowed from the bank and the bank has also borrowed from that same customer. That is the key to understanding this MAGICAL process. The bank and its customer both agree to borrow from each other at the same time!

So, when lending to a customer, a bank will simultaneously record that the customer owes it money and that it owes the customer money. Simple… but also a bit complicated. Why would both parties agree to this?

Well, let’s try to put yourself into the mind of the customer. Why would you agree to this deal??? You have to repay the bank far into the future. The bank has to repay you on demand. That means whenever you want. All you need to do is go to an ATM and exchange what is recorded in your bank account to cold hard cash. What is more, the debt the bank has to you can be used as money. You can use your bank account to pay other people, right? This is why economist say that banks have the power to create money. Because you can use their debt to buy anything you want.

Now if you put it like that, it actually sounds like a bad deal for the bank and a good deal for you. Probably not what you might have expected when you learned that banks have the power to create money. So, what is the catch? The catch is that you have to pay for the privilege. You pay the bank more than it pays you. The interest rate on loans is higher than the interest on bank accounts.

As long as enough customers will repay their loans, it is profitable for the bank create loans like this. So, it is in the banks interest to create money by lending to customers. And that is exactly what banks love to do. In fact, commercial banks have created so much debt and money that in most modern economies, money created by commercial banks is by far the biggest share of the all money in the economy. This wasn’t always the case, just after the second world war, cash and money accounted for 50% of the money supply.

So, let’s go over the two most important differences with the money multiplier story. The first is about the order of events and the second is about what constrains money creation. The first difference is all about timing. If we believe the money multiplier story. The timing is as follows. Step 1: the central bank creates cash which then ends up in the economy. Step 2: people bring cash to the bank. Step 3: banks keep a fraction of that cash at the central bank and lend out the rest. This is the money creation part. Step 4: this will happen again and again till it is no longer possible. Now, contrast this to the timing of the actual money creation story. Step 1: a customer goes to the bank for a loan. Step 2: The customer and bank both issue a debt. The debt the bank has issued is newly created money. Step 3: The customer will use this to make payments. Alternatively, the customer can go to the ATM to convert bank money into cash. This is facilitated by the central bank which will lend it out to the bank provided that the bank made prudent loans. The money multiplier story starts with the central bank creating cash and someone bringing that to a bank. In real life, no initial central bank money is needed for loans to be created. That is a clear difference. So, does that mean that central bank money or –reserves—don’t matter at all? Well that brings us to the second difference. The second difference is all about what keeps banks from creating unlimited money. The money multiplier story is very clear on this. The total amount of money is constricted by the reserve requirement which is set by the central bank. There is just one tiny problem with this.

Reserve requirements do not constrain money creation. Let me tell you why. The most important reasons why reserve requirements do not matter is because almost all central banks have a policy in place that facilitates reserve creation on demand. What do I mean by that? It means that if a bank goes to the central bank and asks for more reserves, the central bank will almost always create them and lend them to that bank. So, yeah, as you can imagine, that kind off does away with the reserve requirement limit on money creation. If central banks create more reserves on demand, then banks will ask for more if they are ever at risk of hitting the requirement ratio.

And, if that was not enough, for those of you living in Canada, the UK, New Zealand, Australia, Sweden and Hong Kong. In your countries, the reserve requirement is 0%, and has been so for years. How is that going to limit money creation? Subtitle: What are the limits money creation by banks?

So, banks money creation is not limited by reserve requirements. But, if banks are not limited by the reserve requirement in their money creation, does this mean they are not constrained whatsoever in creating money? No, not quite. Yes, banks create money when they lend out money. But, they are not the only party involved. They need their customers to demand for loans. Banks cannot lend if no-one is willing to borrow. This could be an explanation of what is happening in much of the industrialized world. Even though central bankers are trying their hardest to motivate banks to lend more by lowering the interest rates or even buying up debt, lending has been slow to pick up. Not very surprising, since many of their customers are already to their necks in debt.

Another reason why banks cannot keep on creating more and more money is that the law requires that they have a certain amount of their own capital to back up their loans. In many economies this ratio is something like 7-8%. Like with reserve requirements, this does not, however, put a hard ceiling on the total amount of money banks can create. Why? Because banks can issue more capital which the public can purchase. That being said, this does make it more difficult for banks to expand too rapidly. Especially since multiple banks compete with each other. If one bank starts lending too much, its stock price might tank. Therefore, banks will often voluntarily hold liquid assets that are (slightly) above the required ratio.

This also leads us to the third constraint on bank lending, that is liquidity. Not only do banks need to hold a certain percentage of their asset as liquid assets, such as cash or reserves, people might start believing that a bank has expanded too quickly and will not be able to pay out the money they have there. Even in our modern day and age, bank runs take place. Yes, the central bank will lend reserves or cash to these banks if they made sensible loans. But if they didn’t…. they can still fail. If that happens, small savers will get their money back from the central bank. But it can take up to half a year for the central bank to reimburse them. So, therefore the threat of a bank run is still there. This limits the ability of banks to expand too quickly. Again, it is not a hard limit but it is a limit nonetheless.

So let’s wrap this up. Yes, banks create money. No, they do not do so by getting cash from you and then lending over and over till they reach the reserve requirement limit. The reserve requirement is not a hard limit on money creation because central banks create new reserves to support healthy but cash strained banks. Remember, even though banks can technically ‘create money’, they can still fail because they do have to pay back that money. There are some other important soft limits on bank money creation though. These are the public’s demand for debt, capital requirements, and liquidity concerns.

Written on February 20, 2020