How Banks make money out of thin air
Dear readers, today we will talk "How Banks make money out of thin air".
Most of you are familiar with the ability of Central Banks to print money out of thin air. With the help of printing machines and a couple of clicks on a central server, central banks of different countries can create an unlimited number of physical banknotes and electronic money. However, central banks are not the only entities that create money. Money is also created by regular banks such as JPM, Wells Fargo, Barclays, Deutsche Bank, Sberbank, VTB, Tinkoff, etc.
This is possible due to fractional reserve rules that originate with the advent of the banking system itself. Banks increase the money supply (“money creation”) when they lend to borrowers a portion of the money they receive from their depositors. For example, the required reserve ratio for credit institutions in a country is set at 8%. When a bank client places a deposit of $1.0 million, then bank leaves $80 thousand in its correspondent account with the Central Bank, and issues $920 thousand on credit to borrowers. In the end, everyone is happy - the borrower bought an apartment and thereby created demand and jobs in the economy, the bank earns interest income, part of which it gives back and pays to the depositor as interest on the deposit. But this is just the tip of the iceberg. The borrower, who took out a loan for an apartment from Bank, transferred it to the developer’s bank account, opened in the same or in any other bank. Of the amount received, the bank leaves 8% in a correspondent account with the Central Bank, and the remaining 92% is issued on credit again. And so on. On the tenth circle, the initial $1.0 million of “real money” will turn into $7.9 million of money in the form of “debt obligations”, and on the twentieth - into $10.1 million.
The twist is that the bank earns its “modest percentage” from each turnover of this virtual money, which is a form of promissory note. Now imagine that the required reserve rate is 100%. In this case, the bank will not be able to issue loans at the expense of depositors’ money, and the depositor has no interest in placing money on deposit. Economic development has come to a standstill. On the one hand, if it weren’t for the banking multiplier (that’s what this mechanism is called), humanity would still be traveling on horse-drawn carts along dirt roads. On the other hand, are you ready to entrust the bank with 92% of your money with the right to invest literally “in anything and anyone”? No matter how one views it, the banking multiplier is certainly a brilliant invention. For this reason, shares of large banks are included in the portfolios of many celebrity investors, including the legendary Warren Buffett. Agree, knowing how banks work, you no longer want to be content with a modest deposit percentage when you can invest in their entire business. This is how people become investors...
