Banks and money creation
Banks do much more than store money. Through lending, they create most of the money in a modern economy.
What banks do
Banks accept deposits, make loans, and run payment systems. They perform maturity transformation: taking short-term deposits that savers can withdraw at any time and making long-term loans like mortgages. This is valuable but makes banks vulnerable if many depositors want their money at once.
Bank balance sheets
A bank's assets are what it owns or is owed: loans, securities, and reserves (cash and deposits at the central bank). Its liabilities are what it owes: customer deposits and borrowings. Bank capital (equity) is assets minus liabilities, a cushion that absorbs losses.
How lending creates money
When a bank makes a loan, it credits the borrower's account with a new deposit, creating money. As the Bank of England explained in 2014, commercial banks create most money this way: 'loans create deposits'. When loans are repaid, money is destroyed. Bank lending is limited by profitability, regulation, capital, and demand for loans.
The money multiplier
Textbooks often describe a money multiplier: with a reserve requirement of \(rr\), each dollar of reserves supports up to \(1/rr\) dollars of deposits. With a 10% requirement, that is 10 dollars. In practice, modern central banks target interest rates rather than the quantity of reserves, and the US set its reserve requirement to zero in March 2020, so the simple multiplier is a rough illustration rather than a precise rule.
Bank runs
If depositors fear a bank will fail, they rush to withdraw, and because most deposits have been lent out, even a healthy bank can collapse. Runs were common in the Great Depression. In March 2023, Silicon Valley Bank suffered a rapid digital-era run, with depositors trying to withdraw about 42 billion dollars in one day, and was closed by regulators.
Deposit insurance
Deposit insurance guarantees deposits up to a limit (250,000 dollars per depositor per bank in the US, through the FDIC, created in 1933). Knowing their money is safe, small depositors have little reason to run. The downside is moral hazard: insured banks may take more risk, which is one reason they are regulated.
Capital and liquidity requirements
Regulators require banks to hold enough capital to absorb losses and enough liquid assets to meet withdrawals. After 2008, the international Basel III standards raised required capital and introduced liquidity rules. Stress tests check whether big banks could survive severe recessions.
Worked example
A bank has 1,000 million in assets and 920 million in liabilities, so capital is 80 million: a capital ratio of 8%. If loan losses reduce assets by 50 million, capital falls to 30 million. A loss of more than 80 million would make the bank insolvent, with liabilities exceeding assets.
Key takeaways
Banks take deposits, make loans, and transform short-term funds into long-term lending. Capital is assets minus liabilities and absorbs losses. Banks create money when they lend: loans create deposits. The money multiplier is a simplification. Bank runs can topple even healthy banks; deposit insurance reduces runs but creates moral hazard. Capital and liquidity rules make banks safer.
Flashcard
Short-term deposits fund long-term loans
Check your understanding
When a bank makes a new loan by crediting the borrower's account, what happens to the money supply?