The deposit multiplier creates the opportunity for a bank to increase profitability, but it can also increase the bank's liability and make it more vulnerable. When the deposit multiplier increases, and the percentage of deposits kept in bank vaults decreases, banks make more loans. Loans can generate interest and fee income. The flip side is loans increase the total amount of claims against the bank's deposits, so the bank must hope most depositors do not need to withdraw cash at the same time.

Fractional Reserve Banking

Under a fractional reserve banking system, banks do not have to hold on to all of the money deposited by their customers. Rather, banks can lend out some of the deposits in the form of mortgages, car loans, etc.

When this happens, the total pool of money, which is money and not real wealth, in the economy increases exponentially. For example, if banks were required to keep 25% of their reserves and could lend out the other 75%, they would need $1 on hand for every $3 in loans. Since there are four times as many dollars as original deposits, the deposit multiplier is equal to four.

Bank Profitability

A bank's profitability hinges on a lot more variables than just the deposit multiplier. There is no doubt, however, that a larger multiplier makes it easier for banks to earn profits. There are two ways to prove this result.

Banks do not give loans out of charity; loans need to make money to offset the bank's risk. A larger deposit multiplier makes it possible to create more loans, which increases interest income and the opportunity for bank fees.

If you really want to know what makes a bank profitable, watch the actions of bankers. Large banks consistently push for lower reserve ratio requirements and, except in deep recessions, are always looking to give loans. No banker would pursue this policy if he did not believe it helped the bottom line.

  1. How does monetary policy affect a bank's deposit multiplier?

    Find out how the Federal Reserve uses monetary policy to impact the deposit money multiplier for American banks, including ... Read Answer >>
  2. How much does M1 enhance the multiplier effect of fractional reserve banking?

    Explore the impact of M1 on the economy and how the Federal Reserve uses it. Find out how the fractional banking system and ... Read Answer >>
  3. What are the Federal Reserve's guidelines on demand deposit accounts?

    Read about some of the Federal Reserve's requirements and guidelines regarding the treatment, safeguarding and processing ... Read Answer >>
  4. What economic indicators are important to consider when investing in the banking ...

    Find out which economic indicators are most useful for investors in the banking sector, especially those influenced by central ... Read Answer >>
  5. How are bank reserve requirements determined and how does this affect shareholders?

    Learn how bank reserve requirements are determined and how bank reserves affect shareholders through improved bank stability ... Read Answer >>
Related Articles
  1. Financial Advisor

    Why Banks Don't Need Your Money to Make Loans

    Contrary to the story told in most economics textbooks, banks don't need your money to make loans, but they do want it to make those loans more profitable.
  2. Investing

    What is a Bank?

    A bank is a financial institution licensed to receive deposits or issue new securities to the public.
  3. Personal Finance

    Explaining the Reserve Ratio

    Reserve ratio is the amount of cash a bank must keep in its bank vaults or deposit into a central, governing bank.
  4. Investing

    Analyzing A Bank's Financial Statements

    A careful review of a bank's financial statements can help you identify key factors in a potential investment.
  5. Investing

    Explaining Term Deposits

    A term deposit (more often called a certificate of deposit or CD) is a deposit account that is made for a specific period of time.
  6. Personal Finance

    Retail Banking Vs. Corporate Banking

    Retail banking is the visible face of banking to the general public. Corporate banking, also known as business banking, refers to the aspect of banking that deals with corporate customers.
  7. Personal Finance

    How Banks Set Interest Rates on Your Loans

    Many factors go into how banks set interest rates for loans. Use this information to negotiate the best possible rate when you're borrowing.
  1. Deposit Multiplier

    A function that describes the amount of money created in a bank's ...
  2. Multiplier Effect

    The expansion of a country's money supply that results from banks ...
  3. Commercial Bank

    A commercial bank is a type of financial institution that accepts ...
  4. Fractional Reserve Banking

    A banking system in which only a fraction of bank deposits are ...
  5. Interbank Deposits

    Any deposit that is held by one bank for another bank. In most ...
  6. Bank Deposits

    Money placed into a banking institution for safekeeping. Bank ...
Hot Definitions
  1. Time In Force

    Time in force is a special instruction used when placing a trade to indicate how long an order will remain active before ...
  2. Retirement Planning

    Retirement planning is the process of determining retirement income goals and the actions and decisions necessary to achieve ...
  3. Drawdown

    The peak-to-trough decline during a specific record period of an investment, fund or commodity. A drawdown is usually quoted ...
  4. Inverse Transaction

    A transaction that can cancel out a forward contract that has the same value date.
  5. Redemption

    The return of an investor's principal in a fixed income security, such as a preferred stock or bond; or the sale of units ...
  6. Solvency

    The ability of a company to meet its long-term financial obligations. Solvency is essential to staying in business, but a ...
Trading Center