Where Do Banks Get Their Money? Fractional Reserve Banking

Do Banks Create New Money out of Thin Air?

**Re-posted after the events of the credit crunch and 700 bailout packages, enjoy the read and learn how the banks got themselves in this mess.**

Here’s the story. Banks keep on lending money, but where do they get it from? Do they borrow from bigger banks who borrow from bigger banks who borrow from the central bank who then prints the money? Is it as simple as just printing more money?

Turns out money creation sometimes appears out of thin air. All banks lend based on a reserve ratio of their deposit: they must keep a certain % of each deposit at the bank but can lend out the rest. Of course, the whole system is dependent on a) the bank being responsible with lending, b) everyone not defaulting on their loans. If these two things happen eventually the system faces massive losses which is what we’re seeing in the current market.

Let’s observe a fictitious situation to help us understand how the bank gets or ‘creates’ their money. Note: when the term ‘bank’ is used in this article it will refer to your bank and not the central bank (Federal Reserve for the US.)


Let’s build a scenario where there is on bank called National Bank (operating as a monopoly). Suppose a person in another country sends $1000 and they deposit it into the bank. This becomes a NEW deposit for the bank (a PRIMARY deposit).

BANK:

Assets

Liabilities

Cash +1000

Demand Deposit +1000

(Primary Deposit)

(Increase in money supply (Ms))

At this point there is no change in the Ms (money supply), only the composition of it. M1 outside bank to M1 in demand deposits.

The bank will now: A) Keep a little in reserve to meet cash demands, B) Lend the rest out to worthy borrowers.

Let’s assume the Bank has a desired target reserve ratio of .15 (15%) to cover customer cash demands (when you go to the bank and withdraw cash). For $1000 they will keep $150 and lend out $850.

When someone borrows the $850, eventually it will reach the bank again (unless they put it underneath their mattress). Remember we are in a one bank scenario (monopoly).
Bank Now Has:

Assets

Liabilities

Cash +1000

Demand Deposit +1000

Loan +850

850

Total $1850

Total $1850

The total Ms is now $1850.

The Bank holds 15% of 1850 in reserve & lends the rest out. This process repeats itself indefinitely until they can no longer lend out money. This whole concept is called: DEPOSIT CREATION MULTIPLIER.

A quick way to determine the theoretical maximum a bank can lend out is this formula:

New Deposit / Target Reserve Ratio =

ex. $1000 / .15 = $6666.67 in new deposits (Ms increases by this much as well).

The theoretical maximum of course depends on whether the target reserve ratio is correct. Some things that affect the max include: a) number of worthwhile borrowers, b) no currency drain, c) no precautionary balances, d) no clearing drain.

Here are some additional items that may affect how much money the bank can create.

Deposit Creation Multiplier (Modifications)

Base case –> $1000 / .15 = $6,666.67

1) Suppose a 5% currency drain = money supply will only expand to $1000 / .15 + 0.05 = $1000/ .20 = $5000

– Final position of bank –
Assets Liabilities
Cash $750 Deposits $5000
Loans $4250

2) Suppose the banks decide to hold additional precautionary balances of 5%
Ms only expand to = $1000/ .15 + .05 + .05 = $4000

3) Suppose banks have foreign currency deposits and choose to hold additional reserves of .02 (2%)

Ms will (only expand to): $1000 / .15 + .05 + .05 + .02 = $3, 703.70

These are simplistic examples of how banks create money using the scenario of a single Bank acting as a monopoly in the banking industry. It may seem like money is created out of thin air but that’s not exactly the case because behind every loan is an asset. Huge trouble develops when the asset becomes worthless (many homes); someone needs to face all the losses.

Also, this does not highlight how the Federal Reserve creates money, they can actually print more money but, again, it’s not out of ‘thin air’, it’s based on the debt created by a debt note usually in the form of a government bond.

Related deposit creation multiplier equations:

TD = ID / crr

Where: TD=change in Total Deposits ID=Initial change in Deposit ccr=cash reserve ratio

 

?R / ?D = r
or
?D = 1 / r × ?R

Where r = the required reserve ratio. This formula tells us how much deposits increase by the multiple   1 / r  > 1 : Since r < 1, 1 / r > 1

1 / r = simple deposit multiplier. When the central bank supplies the system with an addition $1 in reserves, deposits increase by the multiple $(1/r) > $1.

 

Read another related article to money and banking located here.

101 thoughts on “Where Do Banks Get Their Money? Fractional Reserve Banking

  1. Bob

    Greed & because they can. What about off the balance sheet borrowing & lending hehehe…..shhh…. all Monty Pythonish wink wink nudge nudge say no more SAY NO MORE. Lovely little money earner appears never give a sucker an even break. And aren’t we all the suckers. This crash was spot on in time as the baby boomers are about to retire & their Superannuation share savings slashed….some accident. Funny that if all the boomers stopped work the Gov’ts would lose a lot of tax money. Many folk have to work on or go back to work. The many Banksters & Government nutters & regulators would appear to be sitting on their butts in their mansions & laughing like hyenas at the good people suffering at the hands of these modern day white collar leeches who appear protected by many who sail in the Legal System & also the law makers. Good news is people are waking up & doing there own research into the Banking System & cutting thru the fluff & seeing how the system is set up to be flawed & then misused/abused by the money lenders much to their advantage. Then they see how reccesions/depressions & boom are created for the benefit of the money lenders.

  2. Terry Hammonds MSW

    A book published in 2008 titled “The Mystery of Banking” by Murray Rothbard (Second Edition) says bluntly on page 97 that our system of fractinal reserve banking “is a shell game, a Ponzi scheme, a fraud…” Loan money is created out of thin air. Banks hope there will not be a run on the accounts because they do not have enough in reserves to cover panic withdrawls. The scam is run with the full support of the government by insuring accounts through the FDIC. Banks take in the deposits and by financie law, they then own the money. If they squander the money, as they did in this meltdown of our financial system, they can not be charged with theft or embezzelemt. Legally, the money is theirs to do with it whatever they want. If the bank fails, the FDIC gives our money back or the bank gets a bailout and we start over.

  3. nicole

    Hi Guys

    The fact of the matter is that the whole banking system is a scam, we do not need banks, yet we wanted them….

  4. pete

    Nice to find you aussies learning this stuff as I am myself here in the states. Question – what can I or anybody else do to protect ourselves and/or how can I (we) make money to propser in the middle of this fractional reserve banking scheme? How do we bypass the banking system?

  5. Bob

    Pete there ghas to be away. But could be difficult. The opposition from the Banksters would be intense as you are aware of many Leaders who tried through the ages were murdered! Old Abe Lincoln put it something like he did not fear the army in front of him but the Banksters at the back….is that a fair interpretation? Rest his soul.

    Seems the Banksters have a noose around Governments/countries, politiicians throats by law/&or other means . And it seems the Legal Practitioners Union in Australia (Law Society) of which to practice one is expected to join… some years ago….maybe still is….. was sponsored by different Banks at various times….well so the Law Societies Brochures adds said (on the backs of their brochures) …..so any one having a case debated in Court and a Bank was the opposing mob …..one could not help thinking….. maybe there will be some kind of bias towards the Bankster/s. (seems the presiding Beak would not excuse him/herself from the Court even if there was conflict of interest) And just maybe financial documents showing the debt (statement )….. requested by the Judge….. will not be brought into Court & just maybe the Judge will give a ruling in favour of the Bankster whilst the Bankster really is in contempt of Court for not presenting relevant documents….ledger card….. showing loan created by a debt as the 1st entry on the card/account. (FIat money…thin air money)
    And the Bankster gets away with it. It has happened in Australia…….So one could only feel uncomfortable at the relationship between Banksters & Lawyer/Beak, Judge or Legal alternative. Do they get together anyway ???? Maybe drinks, golf, shares, sport,clubs, perhaps other benefits/associations we are unaware of???

  6. I am glad that people on here are waking up to the reality that BANKS CREATE MONEY OUT OF THIN AIR as something which is repayable (ie. a loan). However, the amount they can produce depends on the amount of existing reserves. The latter makes up a very small amount necessary for what is termed credit creation, or fractional reserve banking. If you study any economic textbook the process is outlined but they do not ofcourse express the claim that the money is electronically created out of thin air.

    For those interested in the subject please google MONETARY REFORM on the net..

  7. Mark S.

    What is being described is called LEVERAGING. It all stems from the central bank/federal reserve. They lend money to the banks. The banks lend it to us. This increases the money supply. Then products and services expand as a result of the increased supply of money. The money gets repaid to the feds and the money supply tightens. The feds keep a close eye on the availability of the money supply thru interest rates. If they want a tighter supply of money they increase rates which brings the money back to them quicker. If they want borrowing to increase, they drop rates. This increases the supply back into the market, but may increase inflation. The problem is, the banks are their conduit for this process. Without the banks, they fail too. So, they cannot let the banks fail at any cost. It’s not as complicated as the original article states. It all starts with the federal reserve’s monetary policies.

  8. Mark S.

    As a follow up, we have a fiat monetary system. The feds can print as much as they like. When they inflate the money supply, they devalue the dollar which is a tax on your wealth. When they inflate interest rates, they charge you more which, again, takes more of your money. So, whether you save or borrow, they have control over your financial destiny. Precious metals such as gold and silver which hold their value over time are harder to control since they can’t increase those supplies easily. If you bought a home ten years ago and paid for it in gold, say, 1,000 gold dollar coins, and sold it today for the same 1,000 gold dollaw coins, would you be faced with capital gains? The gold coins would be worth more in dollars today than ten years ago, but the coins themselves would be the same as those you used ten years ago. The feds don’t like that equation. Again, fiat money which they have complete control over and is used to rob you of your wealth is what is at stake here. This is how governments control their people and make slaves out of them. Get off this system and you become free.

  9. barry econ

    THe point of fiat money is that in theory the entire system is supposed to operate with integrity and maturity. If that collapses then you’re in huge trouble.

  10. Chris

    Very interesting discussion, I understand the theory behind the article and it makes complete sense that this would happen in a fractional reverse banking system i.e. savings deposited into a bank result in an exponential increase in credit availability. But I still don’t understand the central banks role, the central banks set the interest rates and this dictates the level of interest with which banks can borrow from the central bank. So a slash in interest rates means that banks can borrow from the central bank more cheaply and therefore supply more credit, releasing more liquidity into the market. But where do the central banks get their money from? and also I understand how the factional reverse banking system increases the money supply but how can banks lend out ALL this money at the same time? I mean how can so much credit be created and their still be enough paper money to go around? for example if bank A takes a deposit of £10 and their is a reserve requirement of £1. Bank A then lends out the £9, this money is then deposited in Bank B. If the guy who deposited the £10 Bank A wants his money withdrawn then bank A is £9 down. Say thats all the money the bank had (for the sake of argument) then the bank has to borrow the money? Does he borrow it from other banks at interest? or from the central bank? Also, u know in the budget report? in the UK? it is always a big deal what the interest rates are set at, because it affects the interest rates for consumers. But it is my understanding ( i may be wrong on this) that when the central banks sets its interest rates it is only setting the rate at which banks can borrow form the central bank. Not the interest rate for everybody, but it does affect the rates for everybody. But why are bank borrowing from the central banks anyway??? why are they borrowing from them at all? and where is the central banks getting it’s money from? I’m really confused, could someone please explain this to me?

  11. barry econ

    It is only a theory remember. The point is the banks are supposed to be mature enough NOT to lend out 90% of their cash. However, at the end of the day (clearing drains) you may find banks borrow from other banks to get more cash to settle accounts (which I believe happened at the 2008 collapse). The central bank pegs interest rates called prime rate, the other banks are supposed to follow suit, but they don’t have to. The best borrowers get the ‘bank prime rate’ which is generally 2% higher than prime.

    Central banks get their money by selling bank notes like bonds (thus removing money supply from the system). They could also sell foreign currency (buying back their own currency)….. Of course, they could simply print more money, but that would increase inflation (but central banks are printing money righ tnow…..)

  12. People are asking: “No new money was created (cash)”. Folks, money we use is NOT the cash. Do you buy a home with 100 dollar bills? Do you buy a car with cash? Many does not even buy groceries with cash. We either write a check or use the credit card. Thus, money is the IOUs that bank has created as your bank account. Yes, your bank account does not have the actuall green cash! But the banks promise to pay you does work like money. Promises to pay (DEBT) is our money supply. Here is a video to explain it how banks create money better:

    http://www.tradingstocks.net/html/banks_create_money.html

    Now, people are saying well, banks should not be doing this, doing that! Folks, bank deposits are guaranteed (on paper) by the FDIC. In reality nobody can guarantee the value of bank deposits in an entire economy. But that aside, this guarantee blinds the depositors. They do not question bank actions. Thus, unchecked, banks feel free to take excessive risk. If they go bust, FDIC pays for it. If FDIC goes bust, tax payer pays for it. If the government goes bust, they will print money and we will get worthless paper for it. But at the end it is a bankrupt system that is created to sustain the life style of bankers at the expense of the real economy that works to create actual value.

  13. Jack Flash

    I think that most of you are wrong in your assumptions that Banks create money from thin air, they don’t, it is YOU who created money from nothing, when you sign a promissory note, you are pledging your future labour, the Bank then gets permission from the government to have this recognised as an asset, It is this asset the Bank wrote the cheque against. If Banks could create money from nothing, what do they need you for? they could just create enough money to pay the National debt. Everyone knows they cannot do this, the critical question is, “Could a Bank create money if no one borrowed from them”?. the answer is NO!. When you recognise that YOU are the creator of money, because only People can create wealth through labour, then you may be able to get a grip on the way things work.
    In the case of a mortgage, your promise is sold on the stock market as a mortgage backed security that the government guarantees and your monthly payment is passed through to the investor, CMHC lays out the whole scheme (scam) on their website. The Bank has no further interest in the mortgage and no risk but they keep convincing you that they hold the note, in fact, they are engaged in fraud when they foreclose.
    But People who are too lazy to ANY investigation keep falling for it.

  14. Aussie Dave

    What I’d like to know is who gave privately owned banks the right to create a publicly owned asset – money? This is surely the right of the Government (on behalf of the people) alone.

  15. Aussie Dave,

    You are asking ” who gave privately owned banks the right to create a publicly owned asset – money?”

    Web of Debt by Ellen Brown is an excellent book to read to understand how entire population is paying interest for the money supply to the private banks for the money that we (our government) could have printed:

    http://www.kondratieffwavecycle.com/web-of-debt/

    If the government simply printed the money and made it the legal tender of the land, then we would not have to pay interest to the bankers for our entire money supply. What we have is financial slavery and people are not aware.

    American Revolutionary War was fought for the right to print our own money and not borrow it from bankers. Andrew Jackson paid national debt and we had prosperity for a while. But then wars, import/export requirements made it harder to sustain our economy without their intervention. Jackson survived assasination attempt.

    Abraham Lincoln rejected to borrow from bankers and funded the civil war with money printed by the government. He was assasinated.

    JFK signed the executive order 11110 and gave the U.S. the ability to create its own money backed by silver. He was assasinated.

    See, some people do not like it if government prints it’s own money instead of borrowing it from the banks and pay interest to the bankers.

  16. Bob

    Mike….appears Caesar went the same way as Abe Lincoln & JFK etc. & maybe a huge religious figure ( he turned over tables of the Leaders who were the money lenders) Appears fatal, in some cases, to mess with these banksters.

  17. Steve

    The Banking system is a global monopoly & has no competition in the market place. It is imposable to have any significant changes forced on it now or ever. The only way is for as many people as possible opt for an alterative income/earnings deposit institute, similar to a “members/individual restricted” fund/super or investment institution only for the personal use of its members. So instead of the bankers club {for the banking trillionairs} you would have the citizens club {for the poor bas****s like you & me} with deposits from members to benefit members. & if governments around the world can support super & investment institutions they can support this as well. When corruption & deceit is so entrenched in a business it is best to take your tread else wear. Don’t even try to fix the banking quandrume we all have to find an alterative.

  18. Bob

    Good post Steve.

  19. RN

    >>Of course, the whole system is dependent on a) the bank being responsible with lending, b) everyone not defaulting on their loans

    You are forgetting about C:
    And c) that enough money, needed to pay the interest, is created in the future plus enough to replace all the money in existence as the mortgages and loans are paid off.

  20. Miles

    You made a serious mistake and need to re-read modern money mechanics

  21. barry econ

    Thanks for your non contribution. Maybe you’d like to actually write something of value to contribute rather than your empty remarks. We’d be happy to post your pro found knowledge (honestly)

  22. carl

    If banks including the reserve make money out of thin air shouldn’t that make the tender illegal it is the same as counterfeiting. It should mean that legally we shouldn’t have to pay taxes, loans or buy items with money. If the banks don’t own anything as a collateral in the first place it voids most contracts etc. Then there is interest which doesn’t actually exist in a physical form so if the whole world did end up paying of every single debt owed there would be no money at all and millions still oweing. 2012?

  23. LG

    I am hoping that some of you bank-savvy folks on this forum can help me. I am being told by a group that is helping people save their homes from foreclosure the following: they are saying that when you sign the papers at the title company, that you are essentially endorsing a check that the bank then takes and is immediately paid the price of your mortgage. Then you pay them again through monthly payments plus interest. They are saying that banks are being paid twice, and that you can sue them for damages because of this. I have never heard this before, and can’t understand how this could possibly be true.

    1. Al

      This is how it goes, your signature is worth money, when you sign a mortgage your loaning the bank that amount, the bank deposit your note as an asset, then your note is turned into a security, sold on the open market, at signing you signed a power of attorney, this is so they can take the house back if you don’t pay them the Leander fees servicing account, you signed a contract with the lender which they did not sign only you, for a contract to be valid 2 signatures must be on it, the bank did not give you one penny of its money, or depositors money, federal law prohibits this, then this lender sells your servicing agreement to another lender, then you pay them payments, If you have a mortgage do a forensic audit this will show you. Lets say you pay for thirty years of payments and now you paid the loan off right, no you didn’t, ask the bank for your note back, they never have it, it was sold from the start.
      So yes the bank was paid 2 times, and many more, but you still don’t own your home, your just the tenant it says so on your deed, and to prove it you pay the state rent each year, in taxes, you don’t even own your car, the state dose. You registered it with the state, gave them controlling interest in it, now you need DL, tag, insurance, and they monetized it to run gov.

  24. Jay070

    LG – Sorry to let you know, but money systems are fraudulent. Banks get to create all the money as interest-bearing debt owed to them. That is why globally governments and people are all in debt and there is NO money. Armored cars round up the debt-notes (Federal Reserve Notes) that temporarily circulate and return them to the banks who then loan them back out at interest. Bankers and their associates profit greatly from this system. The rest of us work hard and never get ahead. Evil in the form of banks runs the world

  25. Jay070

    Phrases like “money multiplier” “fractional reserve banking” are used by those in power to hide the fact that banks are fraudulent and operate to steal what little wealth the poor ever hope to have.

    And then we have the news media lying to us acting as if the super rich pay a lot in taxes when in reality the bloated governments around the world operate to keep the corrupt banking system going. Terrorism? The biggest terrorists are those working on Wall Street everyday – manipulating numbers, debt in order to steal from everyone else.

  26. Bob

    Fed Res Bank Bernacke said on the news last year…….that Fed Res creates money & lends it to the US Gov’t. In other words makes up a figure in the computet & lends it to US. Months later in the News he said they print money……but at that time the printing was halted as the printing press was making errors to the Trillions of US$ printed had to be visusally checked by humans…..heheheh. So does the US Govt buy the printed money at the Feds cost to print or buy it off them @ face value. heheheh. face value we could expect. very healthy profit. heheheh. Interesting the Jon Stewart TV picked up on it & showed Bernacke’s interviews of months apart & this made the Fed Bernacke look….well…..a goose for telling contradictory stuff …..it also it made him look a bit slippery & Capone like. Bernacke blew away all the gobbly gook & untruths learnt by econ lads in a few short sentences…..he virtually said it Feds funds are made from thin air.He forgot what he said months prior…..it was obvious.

  27. barry econ

    You can’t use a news clip as a factoid for economics 😛

    the FACT is that you can’t just PRINT money out of thin air. You must ALWAYS have an asset to back up what you are lending. The problem that happens is when billions of people can’t pay their loans and thus default. That money then is technically tied into an asset, however, that asset depreciated (the house). So banks lose millions of dollars (Which they have).

    So there is no money out of thin air, if there was at the rate some people speculate then we’d have super inflation of the currency (which we are experiencing, but not to the scale that would happen if all the gov’t did was print money).

  28. Bob

    Thanks Barry Mr Bernacke was caught out……..millions of folk think he is an economist…..hmmmm…freudian slips of tongue don’t help your case. I’ll say again the brainwashing of the Economist Uni’s students it would appear is for a purpose to perpetuate the myth that Banks don’t create money out of thin air….Barry….. the Tasmanian Gov’t;s 1935 Select committe report on the money System showed clearly ( & many other investigations by Governments) that funds are created out of thin air….contrary to the brainwshing of the Universities. Many Leaders, eminent Bankers, thier Magazines, Governors of many Banks have said so. Many folk have died thru the afges under suspicious circumstances to protect the Banksters abilitiy to do that…… see my Sept 07 & other posts. Gobbly gook, econo speak, sure does prove any different…..only to make the it all sound so complicated that only the learned….Uni taught folk could see how the system works….however to get econ’s to agree…..well that sure is another thing. Some of us have worked in the Banksters system….& are not proud of it I can tell you…..the tales of skullduggery are plenty.

  29. Jay070

    Sorry barry econ, but your understanding of money in today’s world is way off base.

    For you to say that banks have the money they loan out on mortgages reveals that either you have never studied modern banking thoroughly or you are putting out false information deliberately to make banks look like legitimate businesses.

    Banks never “lose millions of dollars” if they never had it to begin with. Do the terms leverage and fractional reserve banking mean anything to you?

    And if fractional reserve banking is morally acceptable, why are only a chosen few in society allowed to practice it without going to jail. If a non-banker sells something of which he has only one of to twenty people who each think they are buying that entire item, he is guilty of fraud.

    When banks loan out 20 times the “money” (actually just debt-notes) that they have on hand, they are practicing fraud. And in a nutshell, that is modern banking.

  30. Jay070

    Also the reason inflation is not as it appears is because all the money created in our system is still debt owed to bankers. There may be a lot of debt notes out there, but when they aren’t circulating, inflation isn’t so obvious.

    A better way to look at it – bankers and their associates through loans at interest have captured much of the wealth of the world. Since ALL money is created as interest-bearing debt owed to bankers, there is always a SHORTAGE of currency for everyday transactions for the rest of us.

    Banking is the biggest scam in history.

  31. The fractional reserve system works as long as there is confidence in the banks. If the economy gets into serious trouble and individuals are worried about their money in the banks then they will race to the bank to remove the money they deposited. If everyone does this, there is said to be a run on the bank and since the bank only holds 10% of the total deposits they cannot pay everyone back and therefore fail.

  32. It is the best time to make some plans for the future and it’s time to be happy. I have read this post and if I could I want to suggest you few interesting things or suggestions. Perhaps you can write next articles referring to this article. I wish to read even more things about it!

  33. Imagine a dialogue between the bank and yourself: “So now you want me to make new loans,” says the bank, somewhat plaintively. “But suppose THEY go down in value – through no fault of my own!” (The bank means that the economy might tank further and even the best companies will be hard-pressed to pay back debts .) “In that case,” explains the bank, “I’ll lose money on new loans, no matter how duly diligent I’ve been in making them, because of circumstances beyond my control, AND a regulatory mechanism that forces me to declare those losses way too soon!”

  34. An economist

    No one seems to have pointed out that the original example given is actually wrong. (I’ve stumbled on this looking for something else, but had to comment.) The second balance sheet should still show $1000 as both the total assets and liabilities. The “deposit creation multiplier” idea referred to is the theoretical maximum aggregate balance sheet of the banking sector, if there is more than one bank and they all lend to each other and only each other. Its double counting, but that’s allowed in the calculation of M4 money supply, but isn’t allowed on any particular bank balance sheet (which is why the example is so wrong). The double counting in the money supply total may look like creating money out of thin air, but the only time that money was created was when the central bank created that original $1000. (Such an arrangement isn’t very profitable, as the only profit for the sector to share is the differential between the interest paid on the original $1000 and the rate they all charge each other. It also would not help the wider economy.)

    Any bank in the system will be keen to loan money to a non-bank source if they can get a significantly better return than lending to each other. However, this will have the same reduction on the thoeretical max M4 type money supply as an increase in the reserve. The bank has to make sure its interest payment are sufficient to cover loans that don’t get repaid (defaults). If it has too many defaults, the bank goes bankrupt and the government deposit guarantee scheme, the banks shareholders (and depositors) and the rest of the banking sector picks up the losses. If the sector isn’t robust (profitable) enough to pick up its share of the defaults, then a domino effect occurs and you have lost your banking sector.

    Of course, if you get a $400 loan from a bank and buy some land for $200 and spend $200 building a house on it which you sell for $1200 (because the buyer thinks the price will go even higher), you pay the bank back its $400 and you walk off with a profit of $800. The house was bought with a mortgage, so the bank thinks its got a $1200 asset. If it all goes wrong and the asset can only be sold for the $400 it cost for the land and building, then there is a problem. Question: Do you blame the bank which has previously been doing this profitably and paying itself very well, the speculator who built the house (and afterall made a quick 200% profit), or the unlucky speculator who took out a £1200 that they couldn’t pay back?

    1. Ro Econ

      The example does work if we assume that the single bank is only one and is acting as if there were multiple banks in the system. I have added some additional formulas at the bottom of the article to reflect deposit creation multiplier .

  35. Bob

    After all the gobbly gook……

    Mervyn King (current Governor of the Bank of England) reportedly said:-

    Of all the ways of organizing banking, the worst is the one we have today… eliminating fractional reserve banking explicitly recognizes that the pretence that risk-free deposits can be supported by risky assets is alchemy. To work, financial alchemy requires the implicit support of the tax payer… For a society to base its financial system on alchemy is a poor advertisement for its rationality.

  36. An economist

    If Mervyn King said it, he was probably being humourous (Central Banks all work on this principle and have done since we were all born).

    Incidentally, in the previous post, I purposely described a situation without promisory notes (because almost no-one else had mentioned them and the example in the person’s original example wrongly adddressed the issue by ignoring such debt notes). If you allow a bank to issue these promisory debt notes and people accept them, then a bank can (in the original example) have a balance sheet anything up to 100/15 times (about 6.5 times) the total deposits with the remaining $55k or so being made up of promisory notes and the like.

    If commercial banks didn’t engage in this leveraging and promisory notes, then they would basically only be able to use the funds provided by their shareholders and other investors – i.e. most people wouldn’t be able to get a loan.

    1. Dr. House

      You say that like it is a bad thing.

      People’s willingness to sell their future life and livelihood for gratification today is the root problem (and the theme of many, many fables.)
      If people were /unwilling/ to sell their souls and instead insisted on paying themselves for the work they do and saved money they would not become wage-slaves and would be able to modulate their behavior accord to their values.
      Today 99% of the population cannot because 99% of the population so greatly wishes to live beyond their means that they compromise their values in order to do.

      FICO only matters if you are owned by a bank.
      It’s a measure of how good of slave you are.
      Once you are a free man your FICO score becomes 0.

      If you live debt-free then you exit the system and make the banks one iota weaker.
      If, over time, many people stopped living in debt the system would wane in power.

      The religious undertones of all of this are difficult to ignore.
      I am an Atheist so permit me the liberty to recast God as the collective human wisdom of the ages.
      We knew better. We were warned. We didn’t listen.

      1. aussietone

        well put, short and sharp. Yes I’m nearly there, Idon’t own much but I’m practically debt free. and it is a feeling of self power, but as a double edged sword it can feel a little less of a man etc. Just keep thinking beyond the materialistic urge we were warned against and things start to feel better.

    2. aussietone

      Well that is precisely the way it should have stayed, as it was in Australia up until the 90’s when banking deregulations started to take hold. Fortunately our Reserve bank over here is not a privately organised one like in the USA. We should all remember that not everybody should be allowed to borrow too much $ to start with. So what if there is slower growth and thus ,slower profit taking by huge banks and multinational companies. That’s all it has been about. . . How the select fortunate few can maintain and continue to reap in, the vast majority of the world’s economic power and control. Thus they maintain their wealthy status quo.

      If commercial banks didn’t engage in such promisory notes etc. then there would be alot less people aquiring loans (of whom probably should have them anyway) there would be slower global growth (therefore less of an appetite for buying shit we don’t need) and there would also be much less profit being made by “The Banks” and let’s not forget the multinationals… OH NO, that can’t be allowed to happen now can it. The enviroment and the resources of the earth might be stronger and more capable of sustaining us all, but instead we must all be allowed to aquire debt so we can keep a bunch of bankers, economists (no insult intended to the individual) top ranking shareholders, directors etc. and politicians rolling flush with money. The US federal reserve bank should have remained like Australia’s reserve bank. . . NOT PRIVATELY RUN AND CONTROLLED .

  37. Bob

    Well Economist…..Not Golman Sachs fan we hope…….We hope you are helping the Government put the creators of GFS behind bars……heheheh…..
    As James Madison, 4th US President is quoted “History records that the money changers have used every form of abuse, intrigue and violent means possible to maintain their control over governments by controlling money and its issuance”….not in jest as history before him & after him proves….he was right. Many famous Banksters & Leaders say & have said similar things….not in jest. The Reserve Banking system is evil. Ahh…. US beloved Thomas A Edsion once said “Interest is the invention of Satan” Many in the Bankster money chain seem to worship this evil system…& profit by it…of course worship it …destroying many a country & its people.

  38. Bob

    The inhabitants of countries are faced with the scourge that Thomas Jefferson mentions below. Politicians have allowed the scourge to fester & grow. As one lad said …. Banking……..a giant ponzi scheme supported by laws & Judiciary & Politiicans and a giant conga line of other so called learned leeches most joyous to suck the life force out of the community with no conscience.

    Thomas Jefferson said in 1802:
    I believe that banking institutions are more dangerous to our liberties than standing armies.
    If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around the banks will deprive the people of all property – until their children wake-up homeless on the continent their fathers conquered.

  39. Steve

    The financial institutions around the world are past fixing or understanding. You can see how confusion & misinformation has infested the reality of the financial industry. This greatly benefits ongoing corruption witch is precisely what the industry wants. While we are forever discussing, & debating exactly what the financial institutions are, & how they work, they will still be getting there trillion dollar profits, & if not, be bailed out by governments {the public money}grants.
    You {the general public} really don’t need banks. It doesn’t matter where you get your income from; it only counts where you invest it. Bypass the banks. Profit from investments, stocks, superannuation, business ventures; invest in anything but banking/finance institutions. Banks are just glorified middle men that produce nothing & take as much as possible, because they can & no one or nothing can stop them. & while you keep involving them with your wealth, they will always corrupt.
    As for the question, “what is money”? Money is, in the main, just a large IOY. Dose anyone really think that there is a physical dollar out there for every one spent? What do you think would happen if there was a global cyber attack on the finance institutions; witch resulted in destroying all credit & debit records? Would you get all your money in cash? I don’t think so.

  40. se7ensnakes

    In a foreclosure the banks exchanges a paper called a promissory note for a real assets. The trick is to get people to sign in the dotted line. Imagine that a home sells for 200k. 75k went for hiring engineers, architect, land purchase, permits and materials. Another 75k went for labor and rental equipment to aid in building the home. The contractor, subsequently, sells the home for 200k and pockets 50k for his effort. Some credit worthy customer comes along and decides they are going to buy the home and so they put up 50k for down payment and a bank finances the rest, 150k. In a matter of 15 years, depending on the interest rate, the banks would have profited 150k from the interest. The payment of the principal will eventually come unless…something happens to the debtor and he cannot fulfill his promissory obligation. Now the homes goes into foreclosure. The banks gets the house, the previous 50k down payment, all the payments the debtor made to that point. What did the bank need to do to get this deal? Just write out a check to the debtor based on the idea that he will pay it back. It is not that banks loan money from deposits but that banks loans money for deposits. In this system you can imagine why and how Washington is full of politicians who cater to these powerful institutions. The probably have controlling interest in all major companies. The future is bleak for the common worker. There does not appear to be any where to invest money for retirement. inflation will eat at it in the bank. and real estate and the stock market are primarily for the insiders that know when economy is going to take a downturn.

  41. Mike

    What is the 850 liability in the second balance sheet? Since the bank has sold a 850 loan without giving up any cash because who ever the bank lent it too put it straight back into the bank then both the capital and the interest are profit. Profit is still a liability but it is money owed to the shareholders. Have I understood correctly?

  42. Banks are getting desperate these days; bankers have even been known to practically beg customers to deposit money! If you’re wanting to get a loan or line of credit, don’t be surprised if the bank first asks you to make a hefty deposit (in addition to down payment) into a checking/savings account!

  43. Thanks for the informative article! We’ve also written a blog post describing a typical investment bank’s fee structure and outline how investment bankers actually make money. Read it here for more information: https://www.tkomiller.com/blog/how-do-investment-banks-get-paid

  44. ted

    Wow!! the original post is very informative…excellent job. Also many good points are made throughout the replies. I would also add that throughout the process even if the bank fails due to any error. ALL of the money “Siphoned” out of the system into ridiculous salaries and bonuses remains the property of the recipients involved. Thus to many of the execs it is in their best interest to keep the “Gravy train” rolling as long as possible but it’s no skin off their back if and when it grinds to a halt either.

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