How banks create money out of thin air

Do you ever wonder what happens to the money you deposit in the bank? Why banks are willing to pay you interest when they are providing a service to keep your money safe? This is because banks are artificially creating money at the click of a button.

Before we get into that let’s understand the basics of how the financial sector or how the banks work. When you deposit your money at the bank they give you a small amount of interest let’s say 1% then they take the money deposited by you and lend it to other people and businesses while charging a much higher interest rate let’s say 6%, The difference between the interest rates they charge on their loans and the interest they pay on your deposit is the profit that bank makes after expenses.

In order to keep the profit machine churning i.e. to lend more the bank needs to attract more money from deposits because DEPOSITS ENABLES LOANS.

But aren’t the banks supposed to keep your money safe so that you can withdraw your money when you need it? Well to a certain extent yes, Banks have a unique system called Fractional Reserve Banking. This fundamentally means that the banks have to keep a certain amount or a fraction of deposits that need to be held in cash and they can loan out the rest. The fractional reserve ratio is usually around 10% but it may vary depending upon the country and its central bank. This system acts as a cushion for when customers want to withdraw cash from their accounts.

This is where the money-making magic occurs. Let’s say X deposits Rs.100,000 into his savings account in Bank A, If the reserve requirement is 10% Bank A keeps Rs.10,000 in reserve as required and lends Rs.90,000 to another customer. Now, X has RS.100,000 in his account and another person has Rs.90,000 in cash, Suddenly the initial deposit of Rs.100,000 turned into Rs.190,000 worth of money. Now the other customer who has Rs.90,000 deposits the cash into his account in Bank B which holds onto 10% of the Rs.90,000 deposited and loans out the rest to its other customers. Now the initial sum of 100,000 deposited by X has increased to 271,000 and this money will multiply itself multiple times over and the people who’re collecting interest from all this money are the banks.

This is how the banks increase the money supply or the total amount of money in circulation without increasing the physical cash moving around. But something is amiss, in the above sentences I’ve stated that Deposits Enable Loans. But when Bank A lent Rs.90,000 to a customer who then deposited the cash, that created a Rs.90,000 deposit. So a better way to address this equation is that LOANS NECESSITATE DEPOSITS. You might think that the 10% fractional reserve requirement limits how much money a bank can lend but the reality is that these requirements do very little to limit banks from lending, In fact, many banks create loan first then deal with or comply with the reserve requirements afterward by getting new deposit or by borrowing money from other banks at a low-interest rate to satisfy the reserve requirement.

The only thing keeping banks from abusing this system of constantly creating new loans to make more money are as follows:

  1. Profitability- When The Banks make a loan they don’t consider the interest they charge alone, they must also consider the cost of running the bank and potential losses they may face if the borrower is unable to repay.

2. Capital requirements- The amount of capital a bank must hold relative to its total lending or it can be thought of as the amount of profits that must be kept within the bank instead of distributed to the shareholders as dividends.

With these limitations in place, most banks should be relatively safe from failing.

Fixed deposits are sums of money that are deposited for a fixed period of time and usually such deposits are for a period in excess of 3 years and attract higher rates of returns in comparison with the savings bank account. Once a bank attracts a fixed deposit, The bank is assured of how much money will be available with it for disbursal and at what rate of interest enabling the bank to lend the sums made available from the fixed deposit to its potential borrowers and what is the likely profitability and project the business operation and the profitability to that limited extent. Fixed deposits are usually directly proportionate to the profitability of the bank which can be projected more or less accurately in the course of the Bank’s business assuming the funds available with the bank are deployed diligently, save, the unlikely foreclosure of the deposit.

The 2008 crash of the global economy due to banking blunders was offset by several governments across the globe. The support given by the united state of America from and out of its budget amounted to about 245 billion dollars to resurrect the banking system of America and several countries across the globe even went into deficit financing to hold their respective economies in good stead.

Several of the scheduled banks in India are nationalized banks. When one nationalized banks face a loss they are funded by the union budget or they are merged, whereby the loss of one nationalized bank can be offset by the profitability of another nationalized bank.

By such measures, the nationalized banks are kept afloat and the onus of reckless and insufficient lending becomes unaccountable and the burden of keeping the banks afloat directly falls on the citizenry of India who pay both direct and indirect taxes from and out of which the government is funded and it is but rare that the bankers are held accountable.

Under the circumstances, it will only be fair that the government of India, represented by the ministry of finance and the Reserve Bank of India bring in a mechanism to analyze, understand, and to mitigate the loss that occurs through the nationalized banks, so as to put less strain on the people of India who are taxed and the monies so saved can be put to better use such as healthcare, education, environment, infrastructure development, etc…

Just a high school student from Chennai,India trying to express his thoughts.