Banks operate by lending money, but it may surprise you to learn that they don’t actually require your money to do so. In reality, banks only hold a small fraction of their customers’ deposits on hand, while the majority is lent out to others or invested. If banks can make loans without needing your money, then why do they bother collecting deposits? The answer lies in regulations and the interest they can earn on those deposits. In this post, we’ll delve into why banks don’t need your money to make loans and how they utilize deposits to their advantage.
How do loans function? Many people believe that banks need deposits to facilitate loans, but that’s not the case. Banks have the ability to create money out of thin air when granting loans.
Here’s how it works: When a bank approves a loan, it simply credits the borrower’s account with the loan amount. The money doesn’t originate from any external source; it is effectively generated by the bank. This newly created money then enters circulation and is utilized for purchasing items like houses, cars, or businesses.
The key point to understand is that when a bank grants a loan, it simultaneously creates money. Therefore, if you’re wondering why banks don’t require your money for loans, it’s because they can create the necessary funds themselves!
Why don’t banks need your money for loans? The straightforward answer is that banks don’t need your money to make loans because they possess the ability to generate money out of thin air. While it might sound like magic, this is simply how our monetary system operates.
Banks can create money through fractional reserve banking. This involves keeping a certain percentage of deposits (reserves) on hand and lending out the remainder. The legally required reserve amount varies by country but typically hovers around 10%.
For instance, if a bank has $100 in deposits, it can lend out $90 and still fulfill the reserve requirements. As long as customers maintain their deposits in the bank, it can continue lending and generating profits.
However, if everyone suddenly decides to withdraw their money, banks would face challenges. This is why they retain a portion of deposits as reserves—to safeguard against sudden withdrawals.
What are the benefits of this system? The banking system is designed to generate profits for banks rather than primarily benefiting their customers. When you deposit money in a bank, you’re essentially providing the bank with a loan. The bank then utilizes that money to grant loans to others and charges interest on those loans. The disparity between the interest charged on loans and the interest paid to depositors constitutes the bank’s profit.
Therefore, if you’re questioning why banks don’t need your money for loans, it’s because they are already earning significant profits from the money they possess. They can sustain their operations without relying on customer deposits.
Are there any drawbacks? Yes, there are drawbacks to this system. Firstly, if a bank extends numerous loans that borrowers subsequently fail to repay (e.g., during a recession), the bank can encounter financial difficulties. Additionally, if a substantial number of people wish to withdraw their money from the bank simultaneously (e.g., during a financial crisis), the bank may not have sufficient cash on hand to accommodate all withdrawals. This situation is commonly referred to as a “run on the bank.”