How do banks create money out of thin air?

Monopoly board game

Hasbro is a toy and board game company based in the United States, mainly known for Monopoly. In this board game, players compete in buying and developing parcels of land. Players get eliminated as they become bankrupt throughout the game. The last player who remains playing till the end, meaning the only player who doesn’t end up bankrupt, wins the game.

One of Monopoly’s non-playable characters is the bank. Among other things, the primary roles of the bank in the game are to:

  1. Act as a tax collector for the government;
  2. Handle finances related to purchases and sales of properties; and
  3. Give players $200 every time they complete a rotation around the board game.

Like any bank, Monopoly has its supply of money, known as the “Monopoly Dollar”. There’s a limited amount of Monopoly dollars that the game comes with from the manufacturer. There may come a time when the bank runs out of money during the game. Fortunately, the game doesn’t end there, especially if you’re winning.

One of the game’s suggestions says what players should do if they encounter such a scenario.

“Some players think that the bank is bankrupt if it runs out of money. The bank never goes bankrupt. To continue playing, use slips of paper to keep track of each player’s banking transactions – until the bank has enough paper money to operate again. The Banker may also issue “new” money on slips of ordinary paper.”

Banks in the game of Monopoly can create more money than what the manufacturer provided in the game. The process isn’t different from what banks do in reality through what is known as fractional banking.

Fractional banking

Source: Pixabay

Traditionally, banks make money from interest rates and other fees from clients who borrow money from them in loans. The money they lend comes from their other clients’ deposits. The higher the deposits, the more they can lend.

What if I told you that banks could create money legitimately out of thin air? Yes, that’s true. Similar to the Monopoly game example, banks can create money through a process called fractional reserve banking. The process is different from what happens game. Nonetheless, the concept is the same. 

Banks are obliged to keep part of the deposits and can lend the remaining funds to loan seekers.

Borrowers use loans to pay sellers of goods like properties and automobiles. The payment to the seller is now a bank deposit. The same sellers get paid through a bank transfer or cheque deposited in a bank. Again, the bank will keep part of the money and loan out the money once again. 

The bank will continue this process until the original amount deposited by its customer gets depleted. 

To illustrate:

  1. Customer A deposits $1,000 into a bank. The bank keeps 20% as a reserve and loans out the remaining 80% or $800 to client B. 
  2. Client B uses the loan to pay for a property he bought from client C. Client C deposits the $800 he received from client B into his bank account. 
  3. The bank takes the $800 deposited by client C, keeps 20% as a reserve and loans out 80% or $640 to client D.

If the bank is required to keep 20% as a reserve, theoretically, a bank creates $5,000 ($1,000 / 20%) worth of loans from a single deposit of $1,000.

Banks pay zero to nothing on deposits while charging interest rates on loans. They don’t pay any interest on the $1,000 deposit in the above scenario. Still, they charge interest rates and other fees on $5,000 worth of loans.

Now imagine the millions of dollars worth of deposits banks have and the millions of deposits banks get every month from their client’s salaries and other sources of income. Banks potentially can convert them into billions of dollars worth of loans. The process is a multiplier.

All banks engage in fractional banking. It provides retail customers and businesses with credit, the lifeline of most developed economies. Clients and businesses borrow money as they don’t have enough funds to finance their purchases. 


Balancing risks
Source: Pixabay

All businesses are prone to risks, but unlike other industries, banks can bring down a whole economy if they go bust. That’s why banking is probably one of the most regulated industries in the world. 

One of the significant risks banks face is the difference in the lifetime of deposits and loans. Deposits in banks are short term, and clients can withdraw their funds anytime unless they’re in a fixed account. At the same time, loans can span from at least five years to buy an automobile to more than 30 years for a property.

Banks assume that the clients’ withdrawals of their deposits won’t exceed their reserve (the 20% in the above example) and that clients who borrowed money pay their loans. 

Trust is everything in banking. Regulators like central banks and financial regulators impose rigorous regulations to ensure that financial institutions uphold the highest standards to ensure that people trust the financial system.

Unfortunately, bad things happen. Sometimes these happen because banks give loans to people who won’t be able to repay the loan. Sometimes a segment of the population won’t be able to repay their loans due to an economic downturn. Some industries like the hospitality and creative arts lost revenue due to the COVID-19 pandemic.

Other severe economic downturns may include inflation, mass unemployment and a recession. In all scenarios, people will be afraid to spend money. They’ll likely spend money on needs like consumer essentials like food, healthcare and utilities. They’ll forgo products and services considered as wants, such as consumer discretionary items like furniture, technology, finance and industrial goods.

Suppose banks face a scenario where clients withdraw money significantly higher than anticipated. In that case, the bank will be facing liquidity problems. 

Banks can solve this by limiting setting a capping on money’s daily or weekly withdrawal. However, this may be counter-productive, as people can spread rumours that the bank is going bust and people will lose their money. These rumours will cause other people to withdraw their money from banks and worsen the problem for the bank.

Even worse, the problems associated with one bank can induce problems with other financial institutions, better known as contagion. Contagion is when a financial crisis spreads from one financial institution to another and from one market to another. One typical example is the 2008 financial crisis.


Blue door with padlock
Source: Pixabay

Over a decade has passed since the last financial crisis, and regulators may have learned how to better deal with such possibilities. However, one can never be too sure.

Intra-bank loans are when banks take loans from each other for various reasons, such as liquidity problems. However, this can create problems for the lending bank. 

A commonly used strategy by banks is to keep money inside the financial system. When someone withdraws money from an ATM, money leaves the system, meaning banks will have less liquidity. Banks promote debit and credit cards, bank transfers and cheques as a convenient way for their retail clients to purchase goods and services or for businesses to collect their money. 

Money isn’t leaving the bank whenever one uses one of these payment methods. All the bank is doing is recording transactions. One transaction deducts the amount from the buyer’s account, and another transaction adds an equal amount to the seller’s account. Money remains in the same place, except its ownership changes.

In extreme cases, banks are given a cash injection from Central Banks to ensure enough liquidity and tame consumer fears about a possible bank run and financial catastrophe.


Life belt
Source: Pixabay

One of the main criticisms of the 2008 financial crisis is that the US Government was too slow to act and allowed the Lehman Brothers to go bust in the spirit of capitalism. The American Government soon learned that the risks associated with the bank’s fall spread to other banks, which created a global economic crisis.

The US Government responded by giving financial assistance to several industries, particularly financial institutions and automobile industries. A bailout aims primarily to prevent ailing businesses in particular industries from going bankrupt and causing an economic collapse. 

Bailouts may incentivise banks to engage in risky behaviour while knowing that governments will save them. One has to remember that bailouts get paid from the taxpayers’ money.

Hence the saying:

Give a man a gun and he can rob a bank, but give a man a bank, and he can rob the world.


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