How Banks Create Money - How Banks Get Into Trouble

So we all know that banks are a business and that they would do nothing for us if it were not for the prospect of making profits off of us at some point. We have come to expect this of most actors in our society and even accept it - with some exceptions for teachers, social workers and doctors who treat Medicare patients. Now the real question is: How do they do it?

From the consumer's point of view a bank is a place that holds your money. It makes it easy for you to get it out to spend and helps you to make payments and transfer money to other people. If a bank just did this, there would be a problem because these services are not cheap. Even the ridiculous account fees and late fees would probably not cover the costs. So banks do something else.

Most of the time you are not using most of your money. Bankers saw this very early in the game and figured out a way to put your idle money to work for themselves. It's very simple really, the banker sees that only 20% of the money on deposit with her bank is called for on any given day. If she keeps a quarter of her deposits in cash - to be extra safe - she can lend out the other three quarters to businesses or people who want to buy farms and homes. 

If she chooses sound borrowers she gets a steady flow of cash payments, principal plus interest, She uses the interest to run her operation and maybe gives you a little, if competition from other banks forces her to do so. When she does this she creates money. You have a bank account which you treat as cash and the borrowers have cash which they spend, which finds its way into other banks etc. 

In fact, if all banks hold a quarter of their deposits in cash reserves, the banking system will create $4 for every $1 deposited. I will not impose the algebra on you, although it may be found in most economics principles texts.

But this all depends on confidence. If someone spreads nasty rumors about our banker then everybody in town will soon want to get their money out of her bank. Even if she is a sound businesswoman she will not be able to give them their money. Remember It's A Wonderful Life?

If banking depends on public confidence it is also a rich source of temptation to abuse that confidence. If people believe bankers are sound I could start a bank, offer high returns, take in deposits from the public and spend the money on myself. As long as I got enough new deposits to pay interest and take care of old depositors I would be fine. Hello lifestyles of the rich and dishonest.

We have only to look back to the 1980's to see an example of both the abuse of confidence and its failure. Among the results of this debacle was the growth of Fannie Mae and Freddie Mac which stepped in to support the failing mortgage market. For more on this see Paul Krugman's blog today.

I don't know how the latest bank failure happened and I was planning this post before IndyMac had its problems. I do expect that we will see more of these in the near future. I am guessing that most banks are now holding lots of mortgage backed securities. These securities which once paid high returns and could be easily sold for cash are now a real problem.

More on this one next post.


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