- You invest in the bank
- The bank loans your money to someone else at high interest rate
- The bank gets paid, keeps most of the profit and uses a small part of it for your investment.
This is a pretty awful doc. While technically it's not wrong, it doesn't continue to follow the flow long enough. The example given of "creating money" by creating a balance in someone's account is meaningless. In practice, the money is almost immediately sent to... the seller of the house. They may then go pay off their mortgage at their bank... and nothing much has changed.
I can "create money" too, out of thin air. I'll create a line of credit for you. $10,000. Boom, you have money to spend. I made it out of nothing. You have an account with me for $10,000. Problems arise when you actually go to spend it. Do I have enough assets so I can in fact send the money to the seller of the tractor you just purchased? It just became more concrete.
The idea banks make money out of thin air is a stupid idea, it sounds clever but does nothing except muddy the waters. Nobody used to say the local grocer was "creating money out of thin air" when they created a line of credit. In both cases they have enabled more economic activity - and "creating money" as defined by big brains in economic departments at universities is just a fancy, abstract way of saying "enabled more economic activity by creating credit".
"Do I have enough assets so I can in fact send the money to the seller of the tractor you just purchased?"
Yes you do. Because it is just an internal transfer within the bank. From your account at the bank, to the sellers account at the bank.
If it is to another bank, then that destination bank becomes a depositor in the source bank, which creates a loan to the source bank and a new deposit for the seller is created in the destination bank.
The destination bank does this otherwise the seller will move their bank account in disgust to the source bank - who does promise to complete the transfer.
All very simple and the way it has been done for centuries.
How do you know if I have enough assets? I'm just some random finance source.
Sorry, this isn't how it works. To transfer to another bank the banks will adjust central bank balances. Look up how ACH works behind the scenes, or the equivalent in other jurisdictions.
As for "centuries", again, no. Clearing houses - look them up.
In general - if something sounds magical in finance, you have to dig deeper. There is no magic anywhere.
"How do you know if I have enough assets? I'm just some random finance source."
You have enough assets because you've just created a loan of precisely that amount secured against physical collateral. That's the asset.
Therefore I can take over the deposit you have created knowing I can claim against that collateral in the final analysis.
And therefore I can create a deposit for my customer of the same amount.
That's just wholesale deposits.
"To transfer to another bank the banks will adjust central bank balances. "
That's merely a collateral optimisation.
First understand how correspondent banking works, then move to central bank clearing houses.
You'll find that a central bank is nothing more than banks swapping net liabilities with each other. The end result will always be that banks will lend and borrow from each other, and they do that or they lose customers.
A central bank has to accommodate the clearing process, or it can't maintain its interest rate. It can only set price or quantity, not both.
There's no magic, just the fact that a set of banks have pegged their liabilities to each other and one of them acts as a clearing house. It's all just loans and deposits within that.
I can make an unsecured line of credit available to you, and until you try to draw on it, you don't know if I have the ability to fund it. Same problem if the loan is supposed to be secured by your car. There is no magic you can come up with that changes that. Now if you are smart, you'll have done some diligence on me, and I might have a credit rating you can look up. Or someone in your org might be tasked with analyzing the credit and liquidity risks of all their counterparts. If it worked like magic, no one would bother doing this... but they do.
Correspondent banking makes up a tiny percentage of bank to bank settlements. "merely collateral optimization" makes the central bank role sound almost meaningless. Having credit risk and liquidity problems is kind of a big deal.
As for the comments on what the central bank is doing - it doesn't change the fact that banks can't make money out of thin air. If you look at the link above/below for WFC's balance sheet - every asset on their books is funded by real liabilities (plus some equity).
Credit cards are not secured by collateral. A good chunk of corporate loans are unsecured. Just take a look at a real balance sheet of a real bank. Wells Fargo has over $50 bill of just credit card loans. No collateral.
A statement isn't a "game" just because it's inconvenient.
Go through the balance sheet of one of the banks. You'll learn a lot. It will become real instead of some theoretical thing. You'll see how the assets are funded by the liabilities (deposits). You'll see that banks really can't make up money out of thin air.
Here is a simple, real, publicly listed bank in Hawaii:
Go to page 100 and check out the balance sheet. They have about 13 bill of loans out. They own a little over 8 bill of mortgage backed securities. Their total deposits are about 21 bill. Is this some strange coincidence? Of course it isn't.
That is not how fractional reserve banking works, people - or, to me at least, it gives a wrong impression.
Say we are in a fractional reserve banking system, where the required reserve is 10%.
I deposit $1M at the bank. My bank can now lend $900K to you. You can now deposit $900K back at your bank. Your bank can now lend $810K to someone else, and so on and so on.
The geometric sum of this is "1/reserve_ratio"; so if there's a 10% reserve ratio, then the initial $1M deposit can lead to $10M of loans outstanding. No single bank is loaning out more than is being deposited with it.
Banks lend and then try to find reserves, after the fact, because they have legal requirements. No bank loss a good lending business because they have not reserves enough.
When a bank make a loan, there are two possibilities: they have enough reserves, then they don't need to do anything.
Or they don't have enough reserves, so they have to borrow them from other banks or from the central bank.
If they borrow them from other banks they are creating demand for reserves in the inter-bank market. That makes the interest rate go up.
The central banks don't try to control the quantity of money, but the interest rate. If there are a lot of demand for reserves and the Central Bank don't add reserves to the system the interest rate will go up. So, the Central Bank add or retire reserves in order to keep the interest rate in the range they want.
The quantity of money is decided by the demand of lending in the economy.
The Central Bank can choose to try to control the quantity of money or the interest rate, but not both. All modern Central Banks try to control the interest rate.
It doesn't matter because no banks have been anywhere near the reserve requirements that were previously in effect. The change to the "ample reserves" regime is just a tacit admission that lending is not functionally limited by reserve ratios in the U.S. at the moment.
I'm sure you know, but (based on discussions that took place at the time of the announcement back in 2020) I know a lot of people who leapt directly to the assumption that the removal of the reserve requirement was so that banks could "create even more money out of thin air than they were previously allowed to do".
I hope you don't mind me clearing that misconception up, even if it's not for your benefit!
The capital requirements result in something similar. In the end, a loan by JPM of $100 is backed by about $90 of deposits and about $10 of JPM equity. In practice JPM has more capital than that, but there is some adjustments to the loan amount given the risk of any loan etc.
So, JPM needs more equity if it wants to ramp up it's loans.
It's strange if you have a particular conception of money. If you think of money as a social technology used to improve aggregate well being, then it's just a property that empirically makes sense. Private banking, with effective regulation, has proven to be a fairly effective way to stabilize the business cycle and unblock growth
Sure, it helps to improve the aggregate well being of those who participate in the fake economy at the expense of those who participate in the real economy... Great for crooks!
> it helps to improve the aggregate well being of those who participate in the fake economy at the expense of those who participate in the real economy
This is financial Luddism. Just because something is unfamiliar doesn’t mean it’s bad.
Private money creation is necessary for a growing, dynamic economic condition. (The problem is simpler in a static or simply cyclic economy.) Growth is heterogenous. To preserve price and bank stability, you want money created where it’s needed and not in excess where it’s not. In times past, this was largely geographic: banks in the West created money faster than banks in the agrarian South. Today, the divisions are more complex: a bank serving tech companies probably creates more deposits than one serving aging manufacturers.
Centralising this function in a state apparatus has been proposed. But the central bank would have to run and then implement an economic model. Decide where and for whom to create money. This is central planning. It has a poor track record. (This is also the argument against bank concentration [1].)
The way the banking system works now, it mostly creates money where it's not needed. That's why there is such high inequality which keeps growing. New capital is just deployed to chase old capital. It creates anti-competitive moats which prevent money from going where it's really needed and where it could be used most efficiently. It makes bureaucracy viable and economic efficiency non-viable.
The vast majority of people who benefit from bank loans are not value creators, they are rent-seekers. Value creation necessarily requires taking calculated risks and banks these days aren't willing to take any risk.... They need full collateral. It's all about existing collateral. In the short term, the safest investment you can make is to build a moat around your existing investment... But if everyone in the economy is busy building moats (because that's the only activity which is sufficiency safe for banks to fund), there will be nobody remaining to do useful stuff which moves the economy forward.
This is less of a problem with the way that the monetary system operates and more about policy choices made by central banks and politicians after the 2008 financial crisis.
Debt is a promise to return something if value tomorrow for something of value today. Too many promises have been made than will ever be able to be repaid and promises are going to be broken.
Regulators and politicians have three choices on how to deal with broken promises. The first is through bankruptcy courts where a judge allocates losses according to the law. The second is through taxes where politicians take money from one group to honor promises made to another. The third is to drive inflation and break promises by returning dollars that have less value then promised.
This choice that central banks made was the latter by trying to drive up inflation. The side effect of the policy choice however it has tended to favor speculators and the well connected versus other policy paths.
I’m not entirely sure those other paths would have been better. Broken promises tend to be what drives revolutions and the best path is to not make promises that you can’t keep.
It's a good comment, but you left off one important detail on option 3. When choosing the inflation route, there are two ways to inflate the economy by "providing" more dollars.
One option is to provide more money to people/entities that primarily purchase investments/assers. The revenue stream of these investments will roughly remain the same, but their cost will go up permanently. Effecrively increasing "P/E ratios" or equivalent of all assets. This increases inequality in society.
The second option is to provide money to people that primarily purchase goods/services. This increases the demand and thus the price on goods and services, the increased demand pushes up demand for labor, which increases wages and benefits that group. The increased prices of goods/services also increases the value of assets/investments that depend on those revenue streets - but due to the nominal increases in revenues there is no "bubble" increase in "P/E ratios" and equivalent metrics.
2008 did mostly the former and essentially none of the latter.
Covid did a mixture of both, although it coincided with severe supply shortages and oil shocks making its impact unseparable for measuring and not controllable due to the external factors.
The Federal Reserve operates like any other bank with the exception that as a central bank it is exempted from capital ratios and also serves as the Bank for the US Treasury. Because it isn’t limited by capital ratios it can’t absorb losses and so is constrained by US Congress to US guaranteed debt instruments.
If this were not the case and the Federal Reserve were to lose money and be need to be bailed out the Federal Reserve would be making fiscal policy which is reserved to the US Congress by the constitution.
In other words the Federal Reserve would be able to bail out Ford Motors investors (if it wanted to) by simply buying unlimited amounts of Ford Motors bonds at below market rates. This would tend to piss off Congress who rightly believes that the Constitution grants them that authority.
In some cases Congress has granted the Federal Reserve some authority to purchase other assets such as during the 2008 financial crisis. I’m that case a specific amount of money was allocated by Congress. The Federal Reserve ended up leveraging up the allocated funds which ended up working out for the Taxpayer but didn’t make some in Congress happy.
The net-net of that rambling is that the Federal Reserve is fairly limited in what it can buy so it has very limited control over where they money it creates goes. It can flow into assets like stocks or real estate or into consumer loans to purchase groceries if there are people willing and able to assume more debt and banks able to lend it.
Congress and the Federal Reserve working together have more options. Congress can allocate $1 trillion dollars to fund a green energy program and then the Federal Reserve can buy all of the bonds necessary for the Treasury to fund it. The Treasury pays interest on those bonds and the Federal Reserve gives it back to Congress. As long as the Federal Reserve continues to roll the bonds it is essentially “free money”.
Of course nothing is ever really free as this free money transfers purchasing power from people holding cash as they are diluted. This is essentially what happened during covid.
Long term the bill still has to be paid either through taxes or increased inflation (like we’re seeing now) both with consequences for the economy.
If Congress wanted to provide more tools to the Federal Reserve it could provide them with tools to funnel money directly to households. For example creating an “America Saves” program where employers would be required to fund an employee savings account each year invested in US Treasuries which employees could borrow against and interest paid accumulated to the employee.
The Federal Reserve could create money by purchasing Treasuries from these accounts when consumers took out loans and remove money by increasing interest rates and limiting the percentage of assets that could be borrowed against.
It's worth taking a look at the balance sheet of a bank. Most of them will have credit card receivables. A lot of them. No collateral. They'll also have all kinds of unsecured loans.
Banks were never taking much in the way of risk. It's not what they are there for. They are and always have been there to take depositors money and make low risk loans. It is what it is.
It’s the defining characteristic of a banking license. Like any license it permits activity that would otherwise be illegal. In this case, creating new dollars.
"On the hook" right up until the point they're about to go bust, then they hand over responsibility to the government to rescue them from their rampant speculation.
Basically, yes. There are “capital” requirements, but as far as I can tell that’s basically just laundering their loan business by trading equity with peer banks, which are of course largely based on loan performance.
Correspondent banking just seems messed up at the incentive layer... Seems like there is an incentive for banks to just credit free money into each other's accounts... Surely they can create lots of smaller (low profile) banks with accounts all over the place then use this mechanism to print free money for themselves to expand the money supply ad-infinitum. The attack surface is massive. With the same money being loaned and re-loaned across thousands of different banks, how could anyone possibly detect fraudulent currency creation (and distinguish it from genuine deposits)? It just takes one bank to act unethically in a chain of several thousands in order to subvert the entire system.
Even without unethical behavior, it seems like a small chance of human error, when applied across thousands of banks, would cause accidental printed money to leak into the system. For example, there have been many news reports of banks accidentally crediting people with 100x the money which they were supposed to receive; what about all the times when such error occurred but was not detected and did not make the news? That money still found its way into the economy and still contributed to inflation.
The problem can be simply summarized as too many single points of failure.
A homeowner can take $100,000 from a home equity line of credit and drop it into his savings account and create $100,000 in new dollars with a button click. The bank didn’t need to “get” deposits to make this happen as the deposits are created when the homeowner took out the loan. The new dollars and the liability are just entries in the banks balance book but the dollars can be spent like any other dollar at that point.
If the next day the homeowner moved all the money back and paid off the equity the dollars are destroyed. This is how a bank works.
The size of a banks balance sheet and the number of dollars it can create is constrained by the amount of shareholder equity (by regulation). Regulators typically require a 10 to 1 ratio of loans to capital which has potential for fraud.
Just imagine if you had 10 banks levered 10 to 1 and you took all the deposits and put them on black at the local casino. Half of your bets would yield a 10x return on capital and the others you’d lose all your capital (and all your depositors money) but on average you’d make 5x.
Because of the risk banks are highly regulated and regulators require that named individuals that can be held personally and criminally liable for fraud and auditors who also can be held personally and criminally liable as well.
The banks can't print anything. "Money" is a stupidly defined term in econ/finance.
You and I could create IOUs to each other out the wazoo. You owe me $10 mill. It's an asset to me. I owe you $10 mill, it's an asset to you. You and I could go around saying we have $10 mill each in assets. It's not even a lie.
It's why when you enter into a contract for a loan from anyone sensible they want to see your assets and your liabilities. Because our little game above resulted in a net change of 0 for each of us.
Not just that, but I'm going to have a hard time using your $10 mil IOU as collateral for another loan. On the other hand I'd have no trouble whatsoever using a $10 mil IOU from the US Government as collateral. The question is do your liabilities have currency?
If banks could create money out of nothing, then they could not be damaged by a bank run. They would just create enough money to satisfy the run.
The reality is that they can be damaged (or bankrupted) by a bank run, because their books do need to balance. That is why the U.S. created FDIC insurance (which is funded by the banks themselves).
The reason bank run collapses are a thing is that the deposits aren't just sitting there as cash in the vault. Banks invest the deposits and those can't always be liquidated quickly and efficiently in case of a bank run.
If the bank doesn't have enough collateral to borrow the needed cash, the bank is forced to do firesales which is not the best business strategy. Nobody will lend you money when you're selling off your property at a huge discount.
They are certainly related. The reason the deposits aren't sitting there is because they went flying out the door to fund the loans the bank made. If the bank could just fund loans out of thin air, they wouldn't need bank deposits in the first place.
Just go look at the balance sheet of a real bank. You'll see it all balances very nicely - there are assets (mostly loans to businesses and consumers), liabilities (mostly deposits) and shareholders equity (mostly money shareholders put up). Here is one to look at:
> Just go look at the balance sheet of a real bank. You'll see it all balances very nicely
The first rule of tautology club is the first rule of tautology club. By definition double entry bookkeeping always balances no matter what the operations are. This example in no way refutes the parent claim. Furthermore, the banking system must be reasoned about in aggregate. The entire banking system in the USA is a creature of Congress, and every bank is a member of the Federal Reserve system that Congress created. While a given bank may fail due to the arcane shenanigans of the banking guild, the system in aggregate cannot fail unless Congress itself fails.
Sure... you kind of left off the rest of the sentence there...In this case, what is the "it"? Ie, what specifically are the assets and liabilities?
In this case the loans are largely balanced by deposits. That was the point, and it does refute the parent claim.
If money was made up like folks are suggesting in this thread, then the items making the balance sheet balance would be... something else. I don't know, because it's such a stupid idea.
The reality is actually significantly worse than what parent comment posits. Money gets created out of thin air frequently in banking, it's quite the scheme / sham.
Learning more about how the financial system works is usually upsetting, and in surprising ways. The entire business has a certain ring and scumbag scent to it.
I don't think that's a fair interpretation of money or of what banks are doing.
Imagine that a business has $1M/month of revenue, mostly through a quote and purchase order system where the terms are typically net 30. Then imagine they turn to net 60 or net 15, either increasing or decreasing their cashfrow for a single month. The terms of the invoicing are debt creation. And all debt creation is money creation.
Thinking of money like swapping gold really limits the reality of how money has always functioned in our society. Money and debt are social relations, bonds between people, bonds between individuals and a larger collective. It's a human creation, that's been created again and again over time, and the idea of a money-less society is pretty much impossible to come up with.
We must think of money not as an external thing, outside of humanity, but as an essential part of what humans do and create.
Except that the people who are loaned money withdraw it pretty quickly, and then the bank does need cash from deposits (or from inter-bank lending, but the net amount of that is zero).
> or from inter-bank lending, but the net amount of that is zero
Banks in a crunch don’t look for deposits. They approach the Fed’s discount window [1].
Capital requirements aim to ensure banks have enough high-quality collateral to borrow sufficient reserves in most catastrophes. (When the situation threatens to exceed that threshold, we call it a systemic event.)
Banks cover their funding needs through the interbank market that provides the overnight loans required to balance their books at the end of the day. Banks will raise deposit rates to attract deposits if they constantly find that they need to go to the interbank market to balance their books because it is cheaper.
The discount window is used when the bank is unable to access the interbank market which is usually an indicator the bank is expected to fail. The discount window provides liquidity for high quality assets at high costs (which is why it is called the discount window).
If the bank runs out of high quality assets and can’t raise capital it becomes insolvent (bankrupt) and the FDIC takes over the bank and winds it down.
> will raise deposit rates to attract deposits if they constantly find that they need to go to the interbank market to balance their books because it is cheaper
This is true for the largest banks. For many smaller banks, interbank lending is cheaper than deposits. Particularly if those deposits must come from new customers.
Your model is roughly correct over long, strategic time periods. But in tactical timeframes, deposits are assumed fixed or lightly. (In fact, the post-97 role of money centre banks has been to attract deposits to then lend to smaller banks.)
Yes, if a small bank is in an geographic area experiencing high loan demand the interbank market may be a cheaper source of funds. If the bank also has inefficient infrastructure to service retail customers they may find internal deposits more expensive then the interbank market.
Regulators however are less than thrilled if these imbalances persist long term because banks that rely heavily on hot funds tend to experience runs.
In aggregate no. Why? Because the people who withdraw it pretty quickly pay it to someone else, and that someone else deposits it just as quickly. Very few people want to have north of $10,000 in cash on hand. So sure when I buy a house in SoCal for $2.4 million I withdraw that loan about as soon as it's created, but the prior owner of the house I just bought is going to deposit that check drawing on that newly created loan as fast as he possibly can.
