Why Banks Don't Need Your Money to Make Loans

Is it possible to make money on deposits

The Bottom Line Traditional introductory economic textbooks generally treat banks as financial intermediaries, the role of which is to connect borrowers with savers, facilitating their interactions by acting as credible middlemen.

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Individuals who earn an income above their immediate consumption needs can deposit their unused income in a reputable bank, thus creating a reservoir of funds. The bank can then draw on those from those funds in order to loan out to those whose incomes fall below their immediate consumption needs.

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Fibonacci numbers trading on to see how banks really use your deposits to make loans and to what extent they need your money to do so.

Key Takeaways Banks are thought of as financial intermediaries that connect savers and borrowers. However, banks actually rely on a fractional reserve banking system whereby banks can lend more than the number of actual deposits on hand.

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This leads to a money multiplier effect. In order to lend out more, a bank must secure new deposits by attracting more customers.

Without deposits, there would be no loans, or in other words, deposits create loans. Of course, this story of bank lending is usually supplemented by the money multiplier theory that is consistent with what is known as fractional reserve banking.

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The magnitude of this fraction is specified by the reserve requirementthe reciprocal of which indicates the multiple of reserves that banks are able to lend out.

However, given a particular monetary policy regime and barring any increase in reserves, the only way commercial banks can increase their lending capacity is to secure new deposits. Again, deposits create loans, and consequently, banks need your money in order to make new loans.

How banks actually make money

The loan counts as an asset to the bank and it is simultaneously offset by a newly created deposit, which is a liability of the bank to the depositor holder. Contrary to the story described above, loans actually create deposits.

Now, this may seem a bit shocking since, if loans create deposits, private banks are creators of money.

Why Banks Don't Need Your Money to Make Loans

The reality is that banks first extend loans and then look for the required reserves later. Fractional reserve banking is effective, but can also fail. During a " bank run ," depositors all at once demand their money, which exceeds the amount of reserves on hand, leading to a potential bank failure.

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There two sorts of answers to this question, but they are related. The first answer is that banks are limited by profitability considerations; that is, given a certain demand for loans, banks base is it possible to make money on deposits lending decisions on their perception of the risk-return trade-offs, not reserve requirements.

How Banks Earn their Money

The mention of risk brings us to the second, albeit related, answer to our question. In a context whereby deposit accounts are insured by the federal government, banks may find it tempting to take undue risks in their lending operations.

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For this reason, regulatory capital requirements have been implemented to ensure that banks maintain a certain ratio of capital to existing assets. However, since capital requirements are specified as a ratio whose denominator consists of risk-weighted assets RWAsthey are dependent on how risk is measured, which in turn is dependent on the subjective human judgment.

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As noted above, banks lend first and look for reserves later, but they do look for the reserves. Attracting new customers is one way, if not the cheapest way, to secure those reserves.

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Indeed, the current targeted fed funds rate—the rate at which banks borrow from each other—is between 0. Article Sources Investopedia requires writers to use primary sources to support their work.

These include white papers, government data, original reporting, and interviews with industry experts.

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Board of Governors of the Federal Reserve System. Joseph A.

We explain why in this blog post. Ever wonder why some banks give you money to switch?

Routledge, Federal Deposit Insurance Corporation.