Banks, despite being in the business of loaning money, don’t actually need your deposits to make loans. It may seem counterintuitive, but banks only keep a small fraction of customers’ deposits on hand and use the rest for lending or investments. So, why do banks bother collecting deposits if they don’t need them to make loans? The answer lies in regulations and the interest they can earn on those deposits. In this post, we will delve into why banks don’t require your money to make loans and how they leverage deposits to their advantage.
Understanding how loans work: Contrary to popular belief, banks don’t need deposits to fund loans. In reality, banks can create money when they make loans.
Here’s how it works: When a bank approves a loan, it simply credits the borrower’s account with the loan amount. This money is not sourced from anywhere; rather, the bank creates it out of thin air. The newly created money enters the economy and is used for purchasing items like homes, cars, or businesses.
The key point to remember is that when a bank grants a loan, it is simultaneously creating money. Hence, the reason banks don’t need your money to make loans is because they have the ability to generate the required funds themselves.
Why don’t banks need your money to make loans? The straightforward answer is that banks don’t need your money to make loans because they have the power to create money. While it might sound like a magic trick, this is simply how our monetary system operates.
Banks are capable of creating money through fractional reserve banking. This involves banks keeping a certain percentage of deposits as reserves and lending out the remaining amount. The legally required reserve ratio varies across countries but is typically around 10%.
For example, if a bank has $100 in deposits, it can lend out $90 and still fulfill the reserve requirements. As long as people keep their money in the bank, the banks can continue lending and generating profits.
However, if everyone suddenly decides to withdraw their funds from the bank, it can pose a problem. This is why banks maintain a portion of deposits as reserves—to safeguard against sudden withdrawals.
Benefits of this system: It’s important to note that the banking system is designed to generate profits for banks rather than solely benefitting customers. When you deposit money in a bank, you are essentially granting the bank a loan. The bank utilizes that money to provide loans to others and charges interest on those loans. The difference between the interest earned from loans and the interest paid to depositors constitutes the bank’s profit.
Hence, banks don’t require your money to make loans because they are already making ample profits from the money they possess. They can sustain their operations without relying solely on customer deposits.
Are there any drawbacks? Yes, there are drawbacks to this system. Firstly, if a bank has issued numerous loans and circumstances arise where borrowers stop repaying them (e.g., during a recession), the bank can face difficulties. Additionally, if a large number of individuals wish to withdraw their money from the bank simultaneously (e.g., during a financial crisis), the bank may not have enough cash on hand to accommodate everyone’s requests. This situation is referred to as a “run on the bank.”