Why Banks Does not Need Your Money to Make Loans

The traditional role of financial intermediaries in introductory economics textbooks is to connect borrowers and savers, facilitating their interactions by acting as credible middlemen.

Individuals whose income exceeds their immediate consumption needs can create a financial reserve by depositing their surplus income in a reputable bank. The bank may then use these funds to make loans to individuals whose incomes fall below their immediate consumption needs. Learn how banks actually use your deposits to make loans and the extent to which they require your funds to do so.

• Banks are viewed as financial intermediaries connecting savers and borrowers.

• However, banks rely on a fractional reserve banking system that allows them to lend more than the number of actual deposits they have on hand.

• This has a multiplier effect on money. If the amount of reserves held by a bank is 10%, for instance, loans can multiply money up to tenfold.

How It Works

According to this depiction, a bank's lending capacity is constrained by the size of its customers' deposits. A bank must secure new deposits by attracting more customers in order to lend more. Without deposits, there would be no loans; deposits generate loans.

Typically, this account of bank lending is supplemented by the money multiplier theory, which is consistent with fractional reserve banking.

In a fractional reserve system, only a portion of a bank's deposits must be held in cash or on deposit at the central bank. This fraction's magnitude is determined by the reserve requirement, whose reciprocal indicates the multiple of reserves that banks can lend out. If the reserve requirement is 10% (i.e. 0.1), then the multiplier is 10, indicating that banks can lend out 10 times their reserves.

The capacity of banks to lend is limited not solely by their ability to attract new deposits, but also by the central bank's monetary policy decisions regarding whether or not to increase reserves. However, given a particular monetary policy regime as well as barring any increase in reserves, commercial banks can only increase their lending capacity by acquiring new deposits. Again, deposits generate loans; therefore, banks require your funds to create new loans.

The Board of Governors of the Federal Reserve System reduced reserve requirement ratios to zero percent in March 2020, effectively eliminating them for all depositories.

Banking in the Real World

The vast majority of money in the modern economy exists in the form of deposits, but rather than being formed by a group of savers entrusting a bank with their funds, deposits are created when banks extend credit (i.e., create new loans). Joseph Schumpeter once wrote, "It is much more accurate to say that banks "create credit," i.e., that they create deposits in the act of lending, than to say that they lend the deposits entrusted to them."

When a bank makes a loan, it makes two entries on its balance sheet, one on the assets side and another on the liabilities side. The loan is an asset for the bank, which is offset by the newly created deposit, which is a liability for the bank to the depositor. Contrary to what was stated previously, loans create deposits.

Given that loans generate deposits, private banks are essentially money-creating institutions. But you may ask, "Isn't the central banks' sole right and responsibility to create money?" If you believe that the reserve requirement is a constraint on the ability of banks to lend, then yes, in a sense banks cannot create money even without central bank either relaxing the reserve requirement or raising the number of reserves in the banking system.

The reality is that the reserve requirement does not act as a binding constraint on banks' ability to lend and, by extension, their ability to create money. The reality is that banks extend loans before looking for the necessary reserves.

Banking with fractional reserves is effective, but it can also fail. During a "bank run", depositors demand their money all at once, exceeding the bank's reserves and resulting in a possible bank failure.

What Really Influences Banks' Lending Capabilities?

Therefore, if bank lending is not constrained by the reserve requirement, are banks constrained in any way? This question has two types of responses, but they are related. The first response is that banks are constrained by profitability considerations; given a certain demand for loans, banks support their lending decisions on their perception of the risk-return tradeoffs, not reserve requirements.

The mention of risk leads us to the second, albeit related, response to our inquiry. When deposit accounts are insured by the federal government, banks may be tempted to engage in excessively risky lending practices. Since the government insures deposit accounts, it is in the government's best interest to discourage banks from taking excessive risks. In order to ensure that banks maintain a particular ratio of capital to existing assets, regulatory capital requirements have been implemented.

If there is anything that limits bank lending, it is capital requirements, not reserve requirements. Due to the fact that capital requirements are specified as a ratio with risk-weighted assets (RWAs) as the denominator, they are contingent on how risk is measured, which in turn depends on the subjective human judgment.

Some banks may underestimate the riskiness of their assets due to a combination of subjective judgment and ever-growing profit-seeking. Thus, even with regulatory capital requirements, the constraint on banks' ability to lend retains a significant degree of flexibility.

The Bottom Line

Therefore, expectations of profitability continue to be one of the primary constraints on banks' ability or, more precisely, willingness to lend. And for this reason, although banks do not require your money, they still want it. As stated previously, banks lend first and then seek reserves, but they do seek reserves.

Attracting new customers is a method, if not the most cost-effective method, for securing those reserves. As of June 16, 2021, the current targeted fed funds rate — the rate at which banks borrow from each other — is 0% to 0.25 percent, which is significantly higher than the Bank of America's standard savings account interest rate of 0.01%. The banks do not need your money; borrowing from you is simply cheaper than borrowing from other banks.