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 kbanks 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.
Thanks for watching!
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