How Banks Create Money Out of Thin Air
The Bank Scene - Cameron Diaz in The Mask, 1994
I’m not sure robbing banks works any more.
Did you know, it’s estimated that less than 8% of the world’s currencies are available in physical form? With even less available at your actual bank.
Our whole financial system only works because we believe in it.
Hang on, don’t banks need to hold a certain amount in cash liquidity - or better yet, in gold?
No. Contrary to popular belief, average banks of the United States of America are only required to keep 3% of their customer’s deposits in cash reserves. Canada, the UK, New Zealand, Australia, Sweden, and Hong Kong have ZERO minimum holding requirements!
As I was saying, money is a fictional concept. It only works because people believe in it.
So where is it? Where’s the money in your bank account? Isn’t that why it’s in a bank account - so it’s safe and accessible? What happens if everyone goes to withdraw their money at the same time?
The bank goes under.
That’s exactly what happened with the recent Silicon Valley Bank collapse.
In USA and Australia, your first $250,000 held at an authorised deposit-taking institution is government guaranteed but that’s about it. To the majority of SVB’s customers, $250,000 was pocket change. Their customer account balances were in the top 1% of holdings across USA. They were particularly large cash deposits which of course made their owners prone to panic when they heard SVB were looking to raise an extra $500,000,000 to plug a large hole in their balance sheet!
In SVB’s case, at the last minute, the US government decided to back all SVB deposits (even those above $250,000) in order to calm the market. But it can’t do that for all banks as that would require trillions of dollars!
So now you know. Banks are not legally required to keep actual cash on hand.
Instead, bank’s use deposits to create money out of thin air. Every time a bank makes a loan to someone, it’s creating money out of nothing. Let me show you how…
Picture this, Jane has $110,000 in her savings account - it says so on her statement.
Sarah, (a customer of the same bank) applies for an $80,000 loan and voila, the bank digitally credits $80,000 into her bank account.
But where did the bank get the money from to supply Sarah with $80,000?
Jane’s bank statement still says it holds $110,000, so it can’t have come from there. Or can it?
Legally Australian banks don’t have any required cash reserve but they are required to have a capital reserve (i.e. on the books only) of around 8%. This means that banks can create money by investing in government bonds and making interest bearing loans on the majority of their deposits without moving physical cash. Regulatory requirements ensure that the loans they make are also able to be repaid. 🤔 Hopefully they’re getting better at this (#GFC2008).
Now this $80,000 is in two places at once:
It’s in Jane’s savings account.
It’s also available in Sarah’s bank account.
There’s also a new amount created - interest charged by the bank on Sarah’s loan.
To take it a step further, let’s say Sarah spends that loaned money and the receiver puts that money in their bank account. Their bank can make a loan on that money too - which will mean it’s in four places at once!
This is how banks create money out of thin air.
Eventually Sarah will repay the bank for the $80,000 plus interest. In the end, the bank is ahead by the amount interest charged to Sarah but there has been a period of time where the cash was available digitally in more than one place at once.
This is how most of the money in the world is created. It’s called “Fractional-Reserve banking”. It’s one of the biggest reasons why we have so much more digital currency available than physical currency. FASCINATING.
So why didn’t SVB just make more loans?
When interest rates move up so quickly loan applications fall.
The bank itself invested in financial instruments such as government bonds and when interest rates go up, the value of bonds go down.
SVB’s customer base was the tech industry including tech venture capitalists. Most tech start-ups take a while to become cashflow positive. Because of this, many traditional banks don’t loan to tech start-ups. SVB did - it was their primary customer base.
When tech stocks dipped, those tech customers required draw downs on their deposits to fund cashflow. To meet customer withdrawal demands, SVB had to sell off bond instruments for less than they paid for them which apparently led to a loss of $2 billion. Once this was disclosed to the market it led to a classic bank run.
Feeling enlightened on baking systems now? Worrying about whether there will be a run on your bank is not a good use of your time, although diversification between banks will help as your first $250,000 is generally guaranteed.
I’d love to hear from you. Feel free to drop me a comment or question on money, business or mindset in the comments box below.
Legal note: Information provided by Love Luck Wealth is educational in nature and does not take into account your personal financial situation. This does not in any way constitute financial advice.