Hey! You ever wonder what happens to the money you deposit at your bank? And why are they willing to pay you interest when they have to do all the hard work of keeping your money safe?
Now what if I told you that banks are artificially creating money every day? All that and more in today's episode of Five Minute Finance. Let's start with the basics.
You deposit your money at the bank and they give you a small amount of interest. Then, they take that money and lend it to people and businesses while charging a much higher interest rate. The difference between the interest they charge on their loans and the interest they pay you is the profit that the bank makes.
This is why banks are willing to pay you interest for your deposits. In order to lend more and make more money, banks need to attract more money from deposits because deposits create loans. But aren't the banks supposed to be keeping your money safe somewhere so that you can take out your money when you need it?
Well…. sort of. Banks have a unique system called fractional reserve banking, which basically says that only a fraction of deposits, usually around 10%, need to be held in cash and they can loan out the rest.
This amount is set by the Federal Reserve and acts as a cushion for when customers want to withdraw cash from their account. Now here's where the money making magic comes in. Let's say you deposit $10,000 into your savings account.
If the reserve requirement is 10%, the bank must keep $1,000 and can lend $9,000 out to another customer. Now, you have $10,000 in your account, another customer has $9,000 in cash, and suddenly your $10,000 deposit turned into $19,000 worth of money! Then, that other customers deposits their $9,000 at their bank which again holds on to 10% of it and lends out the rest and so on and so on.
You see where this is going. This is how banks increase the money supply, otherwise known as the total amount of money in circulation, without increasing the amount of physical cash moving around. Wait, hold up, hold up, hold up.
Earlier I said that deposits create loans. Banks need to attract more money from deposits because deposits create loans. But when our bank lent $9,000 to a customer who then deposited the cash, that created a $9,000 deposit so isn’t it more correct to say that loans create deposits?
You might think that the fractional reserve requirement limits how much money a bank can lend but the reality is that these requirements do very little to limit banks from lending. In fact, many major banks typically create loans first, then deal with reserve requirements afterwards by getting new deposits or borrowing money from other banks at a low interest rate. So what really keeps bankers from abusing this system of constantly creating new loans to make more money?
Well the first limitation is profitability. When a bank makes a loan, they aren't just thinking about the interest they charge on the loan. They must also consider the costs of running the bank and the potential losses they face if a borrower is unable to repay.
The other major limit on bank lending is capital requirements. Put simply, capital requirements are the amount of capital a bank must hold relative to its total lending. Capital can be though of as the amount of profits that must be kept within the bank instead of distributed to shareholders.
With these limits in place, most banks should be relatively safe from failing but if you're worried about losing the money you deposited at your local bank, fear not! Most banks these days are insured by the Federal Deposit Insurance corporation, or FDIC. The FDIC is a government organization that insures up to $250,000 of your deposits so that your money is safe.
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