How Do Banks Create Money?

2 minutes read

Banks create money because they have banking charters that allow them to do legally what would put the rest of us in jail if we tried it.

Fractional Reserve Lending

The most potent money creating tool is fractional reserve lending. According to the rules of their charters, banks only need to keep a fraction of their deposits in reserve, in the form of cash or other liquid assets.

In the United States, the Federal Reserve (more details about the main reasons for having the Federal Reservesets) the specific percentage banks must keep on reserve. The rate is usually between 3% to 10%, depending on whether the Fed wants to increase or decrease the money supply.

Money Rules For Banks

Federal banks, commercial banks, and savings banks (thrifts) have different rules for loaning money depending on their bank charters.

Although I am oversimplifying a complex process here, the essential point is that banks create money by making multiple loans on the same deposits, as long as the banks keep the required portion on reserve in cash deposits.

It’s worth emphasizing that the Fed usually allows five-to-six times the amount in loans as the amount on deposit.

How Banks Make Money With Mortgage Loans

One of the primary sources of money for banks to use to make more money is mortgage loans. A mortgage loan is an asset on the bank’s books but it is not a cash asset.

Do you want to know how the bank can use your mortgage loan to create new money?

The Bank Sells Your Mortgage Loan

One way is to sell your loan to another bank. Now your bank has cash from the sale of your loan. You still have a loan but your loan was converted to cash by the bank, which means that the bank has a cash asset it can use to make loans to other people.

The Bank Makes Money By Mortgage Securitization 

Another method is through mortgage securitization. In this process, the bank bundles mortgages and then sells bonds based on the mortgages. Mortgage securitization provides cash for the bank to use as assets to create additional loans for other borrowers.

The Seller Deposits The Proceeds Into The Bank 

Another way that your mortgage can turn into money is when you buy a house from a seller, and the seller gets paid by the bank through the mortgage, and then the seller takes that payment and deposits it in a bank, whether your bank or another bank.

How Mortgage Loans Increase The Amount Of Money In The Economic System

This deposit adds more cash into the money supply as a result of creating the loan to fund your mortgage. Every mortgage creates more cash in the money supply, which has the potential of creating more money.

This is just a sample of possible ways that banks can create loans on paper and turn loans on paper into cash to create more loans on paper to create more cash. Fundamentally, banks create more money in the economy by creating multiple loans on the same deposits.

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