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Dr. Kalinda Rose Stevenson
How Banks Create Money Out Of Thin Air
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Bankers are magicians who know how to create money. In fact, banks are in business to make money. They make money using the deposits of their customers. This is why banks provide bank checking accounts and loans. They need money to make more money. The deposits of customers become the raw materials the banks use to make more money.
At this point, the choice of vocabulary is critical. Banks are not just “earning” money. Banks are actually “creating” new money.
Imagine that you deposit $100,000 into a one-year Certificate of Deposit at 5% interest. The bank now can use your $100,000 to create loans.
The Federal Reserve requires banks to keep a portion of their customer deposits on reserve. In other words, the bank cannot loan against the full $100,000 of your deposits. The reserve rate varies between 3-10%. With a 3% reserve rate, the bank is required to keep $3000 on reserve, and can loan the remaining $97,000. With a 10% reserve rate, the bank must keep $10,000 on reserve, and can loan the remaining $90,000. Let’s assume that your bank has a 10% reserve rate, which means it can use $90,000 of your deposit to make loans.
This is the point where the bank does its money magic. It makes a $90,000 loan to a borrower. Now, this $90,000 loan goes on the bank’s balance sheet as a $90,000 asset. This is the critical point at which the bank creates money out of thin air.
The bank does not have to stop with one loan. Since it now has an asset worth $90,000, it can use this asset to make another loan. Again, it must keep 10% on reserve, which means that it can loan 90% of the $90,000. So the bank makes a loan of $81,000. Once again, the bank has created money out of thin air. The $81,000 loan becomes an $81,000 asset.
By now, you can predict the process. The bank uses the $81,000 asset to make an additional loan. After taking out the 10% reserve, the bank can make another loan worth $72,900. In the process, it creates an additional asset. This asset is 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.
This example is oversimplified, but the principle behind the example demonstrates how banks create money out of thin air. When you deposit your money into the bank, it goes into a pool of money available for the bank to make loans. When the bank creates a loan, it creates an asset. This asset is new money.
Since you and I cannot do what banks do, what is the point of knowing how banks create money with customer deposits? The advantage is to take the mystery out of money.
There is no potential limit to money. This process the bank uses to create money demonstrates clearly that money is not a commodity in limited supply, where there is only so much to go around. 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 the difference between earning money and making money in a real estate investing book, “No Money Limits.” Visit http://www.NoMoneyLimits.com for your Free “52 Heart of Money Insights.”
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