A:

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.

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