Banks are typically portrayed as financial intermediates in traditional introductory economic textbooks with the function of connecting savers and borrowers and facilitating their interactions by serving as reliable middlemen.
People who make more money than they need for immediate consumption can place their extra money in a trustworthy bank to build up a reserve of funds. The bank can then use those money to make loans to those whose wages are insufficient to cover their urgent demands for spending. Continue reading to learn how banks actually use your deposits to produce loans and how much of your money is required to do so.
How It Works
As depicted above, a bank’s ability to lend money is constrained by the size of the deposits that its clients make. A bank needs to gain additional deposits by luring in more clients in order to increase its lending capacity. Loans would not exist without deposits; in other words, deposits cause loans.
Of course, the money multiplier hypothesis, which is consistent with fractional reserve banking, is typically added to this tale of bank lending.
Only a portion of a bank’s deposits must be kept in cash or in a commercial bank’s deposit account at the central bank in a fractional reserve system. The reserve requirement, whose reciprocal represents the number of reserves that banks are permitted to lend out, specifies the size of this proportion. Banks are permitted to lend out 10 times more money than their reserves if the reserve requirement is 10% (or 0.1), according to the multiplier.
The ability of banks to draw in new deposits is not the only factor limiting bank lending; the central bank’s monetary policy decisions on reserve requirements also play a role. The only method for commercial banks to grow their lending capacity, given a specific monetary policy environment and barring any rise in reserves, is to acquire new deposits. Again, deposits lead to loans, so banks require your funds in order to originate fresh loans.
Banks in the Real World
The majority of money in the modern economy is in the form of deposits, however deposits are actually created when banks offer credit, not by a group of savers entrusting the bank with retaining their money (i.e., create new loans). It is considerably more accurate to argue that banks “make credit,” which is to say that they generate deposits in the act of lending, rather than to say that they lend the deposits that have been entrusted to them, as Joseph Schumpeter famously stated.
Two matching entries, one on the assets side and one on the liabilities side of the bank’s balance sheet, are created whenever it makes a loan. A freshly formed deposit, which is a liability of the bank to the depositor holder, offsets the loan, which counts as an asset to the bank. Loans, in contrast to the above-mentioned tale, really lead to deposits.
Considering that loans create deposits, private banks are the ones that create money, this may sound a little shocking. But you might be thinking, “Aren’t central banks the only ones with the authority and obligation to create money?” In a sense, banks cannot generate money unless the central bank either relaxes the reserve requirement or increases the amount of reserves in the banking system, assuming you think the reserve requirement is a legally binding restriction on banks’ ability to lend.
The reserve requirement, however, is not a legally binding restriction on banks’ ability to lend, and as a result, their ability to generate new money. In actuality, banks first extend loans before looking for the necessary reserves.
What Really Affects Banks’ Ability to Lend
Do banks suffer any constraints at all if the reserve requirement does not affect bank lending? This question has two different types of responses, yet they are connected. The first response is that banks are constrained by concerns about profitability; in other words, given a particular loan demand, banks base their lending decisions on their perceptions of the risk-return trade-offs rather by reserve requirements.
The second, though connected, response to our query is brought about by the mention of risk. While federal government insurance covers deposit accounts, banks could be tempted to take excessive risks when making loans. Since the government insures deposit accounts, it is appropriate for the government to restrain banks from taking excessive risks. As a result, regulatory capital requirements have been put in place to make sure that banks maintain a specific capital-to-assets ratio.
If there is any restriction on bank lending, it comes from capital requirements rather than reserve restrictions. However, as capital needs are defined as a ratio with risk-weighted assets (RWAs) as the numerator, they are reliant on the method of risk measurement, which is reliant on the subjective human judgment.
Some banks may underestimate the riskiness of their assets due to subjectivity and an ever-increasing desire for profits. Therefore, there is still a substantial level of flexibility in the restriction placed on banks’ ability to lend, even with regulatory capital requirements.
The Bottom Line
Therefore, one of the major obstacles to banks’ capacity, or better yet, willingness, to lend continues to be expectations of profitability. Banks desire your money even if they don’t actually need it for this reason. Banks do look for reserves, despite the fact that they lend money first and then do so.
One, if not the cheapest, way to secure those reserves is by luring in new clients. As of June 16, 2021, the intended fed funds rate—the rate at which banks borrow from one another—was in fact 0% to 0.25%, which is far higher than the 0.01% interest rate that the Bank of America offers on a typical savings account. The banks don’t need your money; they just find it more cost-effective to borrow from you than from other banks.
Learn more: Investment Banks vs. Merchant Banks: What’s the Difference?