How Banks Create Money Out Of Thin Air
Kalinda Rose Stevenson, PhD
Bankers know how to create money out of thin air. In fact, banks are money factories. Banks exist to make money. You might think that banks are in business to provide services such as banking accounts and loans to their customers. It's true that banks provide essential financial services. However, the reason that the banks provide such services is that banks need money to use as raw material to create more money. Where does this money come from? It comes from customer deposits. In other words, it comes from the money you and I deposit into the bank.
At this point, the choice of vocabulary is critical. Banks are not just "earning" money. Banks are actually "creating" new money.
For example: You deposit $100,000 into a one-year Certificate of Deposit at 5% interest. Your money now becomes raw material for bank loans.
The Federal Reserve sets the reserve rate for the bank from 3-10%. A 3% reserve rate means that the bank must keep 3% of the $100,000 on reserve and can loan the remaining 97%. A 10% reserve rate means that the bank must keep 10% of the $100,000 on reserve and can loan the remaining 90%. For our example, let's assume that the reserve rate is 10%. This allows the bank to loan $90,000 of your $100,000 deposit.
This is the critical point when the bank actually creates money. It makes a $90,000 loan based on your $100,000 deposit. This means that the loan to the customer becomes a $90,000 asset for the bank. This is how the bank creates money out of thin air. It now has $90,000 in new money.
It gets even more interesting. The bank does not have to stop with one loan. Since it now has an asset of $90,000, it can make another loan. Again, it must follow the Federal Reserve rules and keep 10% on reserve. This means that bank can make another loan, which is 90% of $90,000. The second loan is $81,000. And once again, the bank has created a new asset. It has created $81,000 in new money.
You guessed it. The bank can use this $81,000 asset to make another loan. It keeps 10% on reserve, and makes a loan of $72,900. And once again, the loan to the borrower becomes an asset to the bank. The bank now has another asset, worth $72,900.
Even though the Federal Reserve allows banks to make five to six loans based on the original $100,000 deposit, we'll stop at three. Each new loan is a new asset, which means new money for the bank. Let's add up how much new money the bank created.
You deposit $100,000 into a CD. The bank creates three loans based on the original $100,000 deposit. Loan /Asset #1 = $90,000 Loan/Asset #2 = $81,000 Loan/Asset #3 = $72,900. The total = $243,900 in assets for the bank. This is $243,900 in new money.
When you cash out your CD, you get your $100,000 deposit back, in addition to the $5,000 interest. Meanwhile, the bank has created $243,900 of new money. After it pays you 5% interest, the bank has made a tidy profit of $238,900. ($243,900 - $5,000 = $238,900.) If the numbers are confusing, go over them again until you see how magical this process is. This is how banks create money.
The process is not as linear as my example. Banks don't make a series of separate loans based on an original deposit. When you deposit your money into the bank, your money becomes part of a large pool of money, which the bank can use to make loans. But my oversimplified example shows how banks use customer deposits to make money out of thin air. You deposit money, the bank keeps some on reserve, and uses the rest to make loans. The loans become assets, and the assets become new money.
The purpose of this example is to demystify money. You and I cannot do what banks do. We can't make multiple loans based on the same money. The value of seeing how banks use customer deposits to create money is to understand how money is created.
The critical point is to see that money is not a commodity. Money is not equivalent to currency. Money is created in money-making transactions.
The point in all of this is that bankers understand something about money that most of us don't know. Bankers know how to create money. They know that the greatest limit to money is the belief that money is limited. If you want more money, ask how you can create money. The real question is: How can think the way a banker thinks? How can you use someone else's money to create more money?
Kalinda Rose Stevenson, Ph.D. Discover how making money is different than earning money in a http://www.nomoneylimits.com/realestateinvestingbook) real estate investing book, "No Money Limits." Go to http://www.NoMoneyLimits.com/ http://www.NoMoneyLimits.com for your Free "52 Heart of Money Insights."
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