Economics and finance generally state that individuals with income deposit their money into banks and banks use those deposits to make loans to their customers. This is not an entirely accurate reflection of how banking and making loans works as this would imply that banks can only lend out the same amount of money that has been deposited with them, which is not the case; banks lend out much more money than customers have deposited with them.
Today, most of the money in circulation is in the form of deposits, which are created when banks make a loan (create credit). When banks make loans, their financial accounting creates two entries: one in the form of a loan asset and one in the form of a deposit liability. Read on to find out exactly how this process works.
- Banks are thought of as financial intermediaries that connect savers and borrowers.
- However, banks actually rely on a fractional reserve banking system whereby banks can lend more than the number of actual deposits on hand.
- This leads to a money multiplier effect. If, for example, the amount of reserves held by a bank is 10%, then loans can multiply money by up to 10x.
Traditional Concept of Making Loans
According to the above portrayal, the lending capacity of a bank is limited by the magnitude of its customers’ deposits. In order to lend out more, a bank must secure new deposits by attracting more customers. Without deposits, there would be no loans, or in other words, deposits create loans.
Of course, this story of bank lending is usually supplemented by the money multiplier theory that is consistent with what is known as fractional reserve banking.
In a fractional reserve system, only a fraction of a bank’s deposits needs to be held in cash or in a commercial bank’s deposit account at the central bank. The magnitude of this fraction is specified by the reserve requirement, the reciprocal of which indicates the multiple of reserves that banks are able to lend out. If the reserve requirement is 10% (i.e., 0.1) then the multiplier is 10, meaning banks are able to lend out 10 times more than their reserves.
The capacity of bank lending is not entirely restricted by banks’ ability to attract new deposits but by the central bank’s monetary policy decisions about whether or not to increase reserves. However, given a particular monetary policy regime and barring any increase in reserves, the only way commercial banks can increase their lending capacity is to secure new deposits. Again, deposits create loans, and consequently, banks need your money in order to make new loans.
In March 2020, the Board of Governors of the Federal Reserve System reduced reserve requirement ratios to 0%, effectively eliminating them for all depository institutions.
How Banks Make Loans in the Real World
In today’s modern economy, most money takes the form of deposits, but rather than being created by a group of savers entrusting the bank with holding their money, deposits are actually created when banks extend credit (i.e., create new loans). As Joseph Schumpeter once wrote, “It is much more realistic to say that the banks 'create credit,' that is, that they create deposits in their act of lending than to say that they lend the deposits that have been entrusted to them.”
When a bank makes a loan, there are two corresponding entries that are made on its balance sheet, one on the assets side and one on the liabilities side. The loan counts as an asset to the bank and it is simultaneously offset by a newly created deposit, which is a liability of the bank to the depositor holder. Contrary to the story described above, loans actually create deposits.
Now, this may seem a bit shocking since, if loans create deposits, private banks are creators of money. But you might be asking, "Isn’t the creation of money the central banks’ sole right and responsibility?" Well, if you believe that the reserve requirement is a binding constraint on banks’ ability to lend then yes, in a certain way banks cannot create money without the central bank either relaxing the reserve requirement or increasing the number of reserves in the banking system.
The truth, however, is that the reserve requirement does not act as a binding constraint on banks’ ability to lend and consequently, their ability to create money. The reality is that banks first extend loans and then look for the required reserves later.
Fractional reserve banking is effective, but can also fail. During a "bank run," depositors all at once demand their money, which exceeds the amount of reserves on hand, leading to a potential bank failure.
What Really Affects a Bank's Ability to Lend
So if bank lending is not restricted by the reserve requirement then do banks face any constraint at all? There are two sorts of answers to this question, but they are related. The first answer is that banks are limited by profitability considerations; that is, given a certain demand for loans, banks base their lending decisions on their perception of the risk-return trade-offs, not reserve requirements.
The mention of risk brings us to the second, albeit related, answer to our question. In a context whereby deposit accounts are insured by the federal government, banks may find it tempting to take undue risks in their lending operations. Since the government insures deposit accounts, it is in the government’s best interest to put a damper on excessive risk-taking by banks. For this reason, regulatory capital requirements have been implemented to ensure that banks maintain a certain ratio of capital to existing assets.
If bank lending is constrained by anything at all, it is capital requirements, not reserve requirements; however, since capital requirements are specified as a ratio whose denominator consists of risk-weighted assets (RWAs), they are dependent on how risk is measured, which in turn is dependent on the subjective human judgment.
Subjective judgment combined with ever-increasing profit-hungriness may lead some banks to underestimate the riskiness of their assets. Thus, even with regulatory capital requirements, there remains a significant amount of flexibility in the constraint imposed on banks’ ability to lend.
How Do Banks Create Loans?
Banks do not create loans from bank reserves or bank deposits. Banks create a loan asset and a deposit liability on their balance sheets. This is how they create credit. The loan creates the deposit, of which reserves need to be held against, provided by the central bank.
How Do Banks Decide to Give Loans?
When deciding to provide a loan, a bank does a thorough credit check on an individual or institution. For an individual, for example, a bank will look at the person's credit history, credit score, current liabilities, current assets, and income from a job, to decide whether a person has a fairly safe credit profile to lend money to; the goal is for the bank to make a decision so they can ensure the money they lend out is paid back.
Do Banks Create New Money When They Loan?
Yes, banks create new money when they make loans. This is done through accounting entries when a bank makes a loan and creates a deposit account.
The Bottom Line
Expectations of profitability, then, remain one of the leading constraints on banks’ ability, or better, willingness, to lend. And it is for this reason that although banks don’t need your money, they do want your money. As noted above, banks lend first and look for reserves later, but they do look for the reserves.
Attracting new customers is one way, if not the cheapest way, to secure those reserves. The banks don’t need your money; it’s just generally cheaper for them to borrow from you than it is to borrow from other banks.