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I have taken some economics courses in university, where I was introduced to fractional-reserve banking. From my understanding, in fractional-reserve banking, the bank has motivation to encourage deposits from depositors, because a large part of these deposits can then be lent out as loans. A small part of the deposits have to be retained as "reserves" (hence the term "fractional-reserve banking"). The bank profits by earning more interest on the loans than it has to pay to the depositors.

However, I read several articles that contradict my understanding. In an article from the Quarterly Bulletin of the Bank of England - Money creation in the modern economy:

The reality of how money is created today differs from the description found in some economics textbooks ... Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits.

[...]

In reality, neither are reserves a binding constraint on lending, nor does the central bank fix the amount of reserves that are available.

[...]

While the money multiplier theory can be a useful way of introducing money and banking in economic textbooks, it is not an accurate description of how money is created in reality.

In light of this, I am forced to re-evaluate my understanding of fractional-reserve banking. The most pressing question I now have is: if banks do not need deposits to create loans, why do they take deposits? What motivates retail banks to allow retail customers to deposit their money if banks have no need for deposits to make loans?

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    $\begingroup$ This is surely a result of the historically unprecedented low interest, which again is a result of the historically low, sometimes negative base interest rates? (Which are an attempt to stimulate investments which don't seem to be able to generate any surplus any longer?) $\endgroup$ – Peter - Reinstate Monica Aug 17 at 12:16
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    $\begingroup$ See also the closely related question on Personal Finance. $\endgroup$ – Tiercelet Aug 17 at 19:21

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I think there are a few separate issues here.

First, semantics: if an institute doesn't let you deposit money into your account, I think we'd be hard-pressed to call it a "bank".

This really doesn't matter to the fundamental aspect of your question, but I think it's of some use. Because a "bank" has to allow deposits (at least by a naive definition, if not a legal one), you're artificially limiting yourself to institutes that do so.

If we broaden the scope of the question to include more than just "banks", we start to get to the meat of the problem.

Second, the real question: why would an institute let you deposit money into their possession to begin with?

I'm sure a hundred super-smart, very educated experts on the subject will give you a hundred and five different answers that are all the absolute, only truth in all the universe.

But the gist of it is that people are willing to pay the bank to safeguard their money. Money in the bank is insured against theft and heavily guarded, so many people would rather have large sums of money in the bank than in their house.

In return, they might pay for the service directly or through microtransactions related to the account. Many banks charge fees for various things, such as cashier's checks, notary services, or financial advice, services you might not bother with if you aren't already in possession of a checking account.

Further, banks can take the money in your checking account and invest it elsewhere (an obvious form of investment being loans to other people). A single, smart person investing a thousand people's money can make enough profit to be worth their while without being directly paid a cent. Scale that up and you get large banking corporations.

Banks often make money off credit card transactions, even if you make payments before any direct interest is due. They also make money off overdraft fees (a form of lending with very high "interest" rates), interest on the credit card (more lending), and so forth.

And, of course, they hope that if you need to borrow money, you'll do it through them.

Third, the side question: do institutes need deposits to make money off loans?

No, they absolutely do not.

Payday loan establishments don't take deposits, instead relying on high-interest, low payback period lending to make their money.

Pawning an item is a form of payday loan with physical collateral: you leave the collateral with the pawn shop and get paid for it, then if you return on time you get most of your money back, with the difference being the shop's fee for the loan. Pawn shops make a lot of money through simply buying low and selling high, but they still make money off pawned items and don't take deposits.

That said, you can only lend money if you have it, so having a large amount of cash sitting in your vault from deposits allows you to lend more money than if you only lend from your own finances. There's more risk involved, but when you start getting thousands and millions of account holders, the aggregate risk goes way down and you can start treating random statistical values like static rates.

Because bank deposits allow the bank to loan more money, it raises the interest they earn on the loans, so it's a good incentive to allow people to deposit into bank accounts.

Fourth, the question not asked: what does the quoted article mean?

I'm not an expert here, but from my reading it's basically just a way of twisting around the semantics to describe how things can be treated in an opposite fashion to common convention, but doesn't actually prove the convention wrong.

The article claims that lending money "creates" that money. This is true to a degree, but is meaningless in the big picture. When a modern bank gives you a loan, they don't actually hand you any physical thing that's worth money. They just write a number on a (probably digital) ledger that says you "have money".

But they can only get away with that because they own assets that are worth real-world value equivalent to the amount they've "created", and because, in the long run, you will give them the amount of money they've lent you, balancing the sheet yourself.

A bank can only get away with "creating" money for a borrower if they can afford to transfer that money to whomever the borrower is trying to buy something from. It does no good to have fictional money if you can't actually spend it, and you can't spend it if the bank doesn't have a commodity the seller's bank wants.

In practice, the commodity transferred is often virtual money established by digital ledgers, but that commodity is very real, and very controlled, and therefore has actual, real-world value. As such, when a bank "creates" money out of thin air, it's doing so by spending a real-world commodity it only regains if you pay back your loan (or they sell your collateral after taking it back).

There's a particularly egregious bit of word-twisting the article makes. It claims:

Bank deposits are simply a record of how much the bank itself owes its customers. So they are a liability of the bank, not an asset that could be lent out. A related misconception is that banks can lend out their reserves. Reserves can only be lent between banks, since consumers do not have access to reserves accounts at the Bank of England.

It's true that reserves themselves can't be lent. That's the definition of the required reserve. But it's also irrelevant. Only 10-12½ % of deposits are required reserves (Bank of England, relevant to the article; other banking systems will have other reserve ratios). The other 87½-90 % of deposits are free to be lent out as desired to make money for the bank. Deposits are absolutely an asset for the bank to lend out in the normal sense of the word. They're also liabilities in a strict sense, but they're liabilities that earn the bank a lot of money.

Imagine you loan me £1000 of tools. I owe you either the tools, in good shape, or £1000, or some equivalent combination. Additionally, I'm probably paying you a fee, say £100 a month, to borrow them. Financially, that's a "liability".

But I'm able to use those tools to earn £5000 a month doing something like construction or automotive repair. In normal speak, the tools are an enormous asset, not a liability. I just need to make sure I can return the tools and borrow other tools if you want yours back.

So while the text is "true", it's also completely misguided in rebuking common "misconceptions". In short, it's using smoke and mirrors to make you think you're wrong about something even though you really aren't.

Summary

Institutes don't require deposits to make money off lending, nor do they require lending to make money off deposits, but the two functions synergize very nicely with each other to create what we would typically think of as a bank.

The article you're quoting is mostly just using some hand-waving semantics to explain how modern banking uses a different mindset to approach the same thing we've been doing for millennia, with virtual currencies replacing physical bases for value.

But there's no epiphany behind the hand-waving; the fundamental nature of what's going on behind the layers of bureaucracy and pedantry hasn't changed since a caveman borrowed one sheep from his neighbor and gave back two sheep the next year.

Note

Most everything I've said is actually written in the quoted article. It talks about how a home loan that "creates" money is then balanced out by the bank paying the home seller's bank. It talks about gaining deposits so the bank can afford to lend more money. It talks about needing to pay interest to the central bank to maintain the assets upon which the commercial bank's finances are based.

The article isn't really bad or inaccurate. It just makes a few over-reaching, semantic claims that don't hold up under scrutiny in an attempt to make you think about banking a bit differently. And those are the claims that threw you off.

It also throws in the concept of growing the aggregate amount of money in the country (the "broad money"), a process typically called "inflation", to maintain a stable, thriving economy. So in that sense, banks do "create" money (though ultimately the central bank does the creation by effectively forgiving tiny amounts of debt here and there through carefully-controlled interest rates as well as simply handing out newly-printed notes), but that's really an entirely different topic that's muddying the issue.

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    $\begingroup$ "I just need to make sure I can return the tools and borrow other tools if you want yours back." Since money is fungible, a bank can just borrow somebody else's money and give that to you when you want your money; they don't have to take it out of whatever investment they've got it in. There's no concept of "your money"; only "the amount of money you have". (Source: Paddington Abroad, chapter 3.) $\endgroup$ – wizzwizz4 Aug 17 at 15:50
  • $\begingroup$ @wizzwizz4 what an excellent source, i see I have much paddington related study to do. $\endgroup$ – Segfault Aug 17 at 17:33
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    $\begingroup$ If I take your answer naively, I would assume that the loans issued by the bank cannot exceed the deposits received by the same. In reality, a bank with only \$1 mm in deposits can easily issue $10 mm in loans. Please explain how this works in your framework. $\endgroup$ – Lawnmower Man Aug 17 at 20:20
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    $\begingroup$ I generally think you are on the right track but there's a lot here that isn't really relevant to what seems to be the main question. If the bank must hold some fraction of the amount it can, lend that answers the question of why the want deposits. The problem with the article is that it suggests that this isn't a factor. But clearly, if the government forces banks to hold reserves, it's a factor in how much reserves they hold and deposits directly relate to that. $\endgroup$ – JimmyJames Aug 18 at 19:01
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    $\begingroup$ "Bank deposits are simply a record of how much the bank itself owes its customers." Utter nonsense. When I deposit \$1,000 in a bank, there is precisely what is described there, a record that the bank owes me \$1,000. But the bank also has the \$1,000 that I deposited, and can lend out most of it. They just ignore that. $\endgroup$ – David Schwartz Aug 19 at 0:19
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This isn't the first time I've seen people claim that this Bank of England article says banks don't need to take deposits, but in fact the article actually says the opposite. In order to make loans banks do need to take deposits or borrow money some other way:

By attracting new deposits, the bank can increase its lending without running down its reserves [...]. Alternatively, a bank can borrow from other banks or attract other forms of liabilities, at least temporarily. But whether through deposits or other liabilities, the bank would need to make sure it was attracting and retaining some kind of funds in order to keep expanding lending.

(Emphasis in the original)

A bank may not strictly need to take deposits, but they do need to borrow money from somewhere and deposits are generally going to be the cheaper and more sustainable option.


It's important to note that when the article talks about reserves, it's talking about central bank reserves, including in the quote above. Central bank reserves can't be lent out to customers, they are instead used to settle debts with other banks:

[...] banks cannot directly lend out reserves. Reserves are an IOU from the central bank to commercial banks. Those banks can use them to make payments to each other, but they cannot ‘lend’ them on to consumers in the economy, who do not hold reserves accounts.

Reserves come into play when the money banks loan to people gets spent. When that happens the the loaned money usually ends up moving from the borrower's account to some other person's account at another bank. This results in the debt the bank used to owed to the borrower, in the form of a deposit the loan created at the bank, now being owed to the other bank. These debts have to be quickly settled, as the other bank has its own debts that need to be settled.

In order to settle debts as a result of transactions like these, banks will use their central bank reserves as payment. If a bank doesn't accept deposits then it will only be paying other banks and will need have reserves available equal (or close) to the amount of its unspent loan deposits. On the other hand, a bank that accepts deposits will also receive reserve payments from other banks offsetting its outgoing payments and reducing the reserves it needs to have available.

Now while central banks don't normally have an arbitrary limits on the amount central bank reserves a bank can obtain, banks don't have an unlimited supply of reserves. Reserves are essentially deposits banks have at the central bank. They can either obtain them by depositing their own money, or by borrowing from the central bank. In order to obtain a loan central banks require collateral. Banks don't have unlimited assets, and while they can collateralize their own loan assets, these have to be sufficiently good quality and their not a unlimited supply of quality loans either.

It's also important to remember that while the interest rates that banks have to pay on central bank loans is less than what they would have to pay for a loan from most other institutions, the central bank's rate is higher than the rate that banks typically pay on deposits. To maximize profits a bank will want minimize the amount of reserves it has in preference for cheaper deposits.


Part of the confusion I think is the people think that banks are creating their own money when giving out loans, when instead it's the borrower's money they're creating. Banks don't directly make money for themselves by giving out loans. As you said, and the article confirms, banks make their own money by lending out money at higher interest rate than they pay on deposits (and other liabilities):

A bank’s business model relies on receiving a higher interest rate on the loans (or other assets) than the rate it pays out on its deposits (or other liabilities).


Ultimately, the point the article is trying to make is that quantitative easing (QE) increases the total amount of central bank reserves, but the total amount of central bank reserves doesn't affect the money supply. Money supply instead primarily affected by the interest rate set on loans by the central bank.

Monetary policy acts as the ultimate limit on money creation. The Bank of England aims to make sure the amount of money creation in the economy is consistent with low and stable inflation. In normal times, the Bank of England implements monetary policy by setting the interest rate on central bank reserves. This then influences a range of interest rates in the economy, including those on bank loans.

...

As a by-product of QE, new central bank reserves are created. But these are not an important part of the transmission mechanism. This article explains how, just as in normal times, these reserves cannot be multiplied into more loans and deposits and how these reserves do not represent ‘free money’ for banks.

The article isn't trying to say fractional reserve banking is a myth, just that there's some misconceptions around it. In particular, the article argues that changing the amount of central bank reserves doesn't change the money supply.

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    $\begingroup$ re "banks cannot directly lend out reserves" - the key word is "directly". As I understand it, the banks can exchange part of those reserves for BoE banknotes, and then lend those banknotes out (and conversely send stacks of used banknotes back to the BoE in exchange for being credited with additional reserves). Typically these transactions are decoupled for the customer too - the loan advance goes into your account, and the banknotes come out of the account as a separate transaction. $\endgroup$ – Steve Aug 18 at 14:27
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I think this perhaps seems/reads like a theoretical chicken-and-the-egg scenario, but IMO it's not really. The reality is just that fiat currency is like magic, and created out of nothing.

Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits

Central Banks print fiat currency. Pieces of paper that by law are given value, and/thus in turn society gives value to. That's what Central Banks do. Other Big-But-Not-Central Banks "sell" government bonds (that they acquire at "auctions" called open market operations) to this Central Bank and in turn get paid in these pieces of paper when and as they need them, i.e to satisfy withdrawals, etc.

With this in mind, to answer your questions:

If banks do not need deposits to create loans, why do they take deposits? What motivates retail banks to allow retail customers to deposit their money if banks have no need for deposits to make loans?

I suppose the answer is many-fold:

  1. Banks do not need deposits from customers to create loans, but they find that by offering those basic deposit services (most people'd rather not keep huge amounts of fiat money under their mattress), and taking those fiat paper deposits, it increases the amount of fiat they need to have on hand for bank operations, and reduces what they have to get from the Central Bank, via the above process.
  2. Turns out that while offering deposit services to customers, banks found out they can also make some ancillary profits from other things, like charging fees, selling checkbooks, selling insurance (etc) and other services to those captive schmucks, err I mean "valued customers" that had to trust them with their fiat deposits.
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  • $\begingroup$ I truly wonder how long the printing press economy will last.... not long is my guess $\endgroup$ – john doe Aug 19 at 19:17
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Banking is confusing, and a lot of explanations apparently make things worse.

In this case, ignore whatever you read, and go back to first principles. By definition: balance sheets must balance. Assets have to be matched by liabilities or equity. However, one defining characteristic of banks is that they have a small percentage of their balance sheets as common equity. By implication, assets are mainly matched against liabilities (including some long-term subordinated instruments like preferred shares, which are considered part of “capital.”)

Deposits are a liability with a relatively low funding cost, and most retail deposits are “stickier” than funding from wholesale debt markets. (Retail investors might take part in a bank run, but the wholesale markets normally panic earlier.) That’s why banks want to keep them.

(There is also the issue of modern banks offering a wide range of financial products. They want to create captive customers for their entire business line.)

UPDATE: Note that if a bank did not accept deposits, it would be a levered non-bank financial intermediary. (Levered means that they are not a pass-through entity, like a mutual fund.) These entities exist. However, they have to follow different strategies than banks, with one key concern being the lack of deposits. (Lack of access to the central bank under normal conditions is another big issue.) So yes, it is entirely possible to act almost like a bank, and not take deposits.

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    $\begingroup$ This just dodges the question instead of answering it $\endgroup$ – Ezekiel Aug 16 at 20:18
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    $\begingroup$ In what sense? Do you believe that banks are not interested in maximising profits? $\endgroup$ – Brian Romanchuk Aug 16 at 21:05
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An individual bank needs deposits, other liabilities, and equity to fund loans so it will attract deposits using deposit attracting strategies.

Some loans are never taken out as currency. A vendor might be selling an investment or a consumption item to a borrower. In that case the lender creates an asset which is the borrower's debt. If the spending is instantaneous such as in an electronic payment then the asset which is the borrower's debt is created at the same time a deposit is made in a vendor's account. The borrower and the vendor are both customers of the banking system (the set of all banks) even if they are customers of different banks. The banking system will then have more assets (borrower's debt) and more deposits and the two amounts increased simultaneously because no currency changed hands. Thus a new loan resulted in an increase in deposits.

Suppose a new loan is taken out as currency. When the loan is spent, the vendor of investment or consumption items will receive income. The income will get deposited in the banking system unless the income earners' propensity to hold currency changed. There is no guarantee an individual bank will attract the deposit but the banking system as a whole will attract the deposit. The banking system will then have more assets (borrower's debt) and more deposits but it wasn't instantaneous because currency was used. Thus for the banking system as a whole, a new loan "created" after some delay, a new deposit.

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What motivates retail banks to allow retail customers to deposit their money if banks have no need for deposits to make loans?

You can expect banks to be controlled by the bean counters. So if a bank accepts deposits, it is probably because it is profitable.

Banking can be divided into retail and wholesale. Many banks have both parts intermnally, some banks do only one part. Accepting deposits from the general public is part of the retail business. The retail works by buying money for a low cost and selling it a a higher price. Part of the cost for is the rent paid to the customer, part is other costs such as computer systems and wages and rents, and the cost of keeping reserves.

There can be situations where deposit rates are used as a part of a package of services, and where the customer as such is profitable regardless of certain products showing losses ( you see that at times at your grocery shop ) .

The retail business sells the money to wholesale businesses, possibly in the same bank. The wholesale as well buys at low cost and sells high. The wholesale will search to source at low interest rate and sell at high possibly through retail outlets.

The description above, simplified as it is, points to there beeing a wholesale price on money, distinct from the interest paid on deposits and distinct from the rent paid by lenders. As there are different "kinds" of lending, think secured property loans compared to unsecured high risk, there will be different "markets" with different prices.

The price of money is generally the interest rate paid. But this is not the full story, as you have to take inflation into account. In a situation with deflation, ie prices go down over time, the interest rate can be negative and still create profit. ( Note, the central bank is not in the business making profit, so the objektives are quite different ).

Now, over the centuries, there has been a multitude of shady companies trying to earn money in various ways. This is one of the reason why banking is extremely regulated. History has bank runs where the depositors lost trust in the banks and tried to remove all deposits at the same time.

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Banks need deposits because they are actually trading in a particular property of money called 'liquidity'.

Money is a legally enforceable, transferable promise to pay the bearer something of real value at a later date. An IOU in essence. But promises differ depending on how quickly you can get hold of that value. Cash, you can spend right now. A contract promising to repay so much a month over the next 20 years has a high value, but it will take you 20 years to get hold of it. The sooner you can spend money, the more 'liquid' it is. What banks do is to swap high-liquidity for low-liquidity forms of money.

When people deposit money in the bank, they put in high-liquidity cash, and get back a low-liquidity promise from the bank to repay it on demand.

When people borrow from the bank, they put in a low-liquidity promise to repay on a fixed schedule, and get back high-liquidity credit, using the deposits to imbue the credit with liquidity.

Fractional reserve banking relies on the fact that usually only a fraction of the money is being spent at any given moment in time. As long as only a fraction of it is needed immediately at any given instant, the cash deposits can cover it, and the credit can thus be spent immediately, like cash. It's not precisely as liquid as cash is because there's always a chance of too much being spent at once. You have a high probability of being able to spend it now, but not certainty. But so long as there are enough liquid deposits in the bank, the probability is high.

The bank is not at risk of running out of money because of this, it has a vault full of loan agreements promising to repay loans with a value sufficient to cover it all. But the value in these loan agreements might take 20 years to access. However, it can run out of liquidity if too many depositors ask for their money back. It may then find it has to sell some of those loan agreements to another bank in exchange for cash, which will generally be for less than their face value. The faster you need it, the lower the value of non-liquid money is.

One of the unexpected implications of this viewpoint is that banks don't actually create money, borrowers do. By promising to repay the loan, the loan agreement you sign is turned into new money. The bank is only trading in liquidity, transferring it from one set of customers to another.

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Banks do not "take" deposits. This would be the case only if the bank were operating as a storage warehouse for gold, silver, paper bank notes, and other forms of circulating money that customers want to be stored in bank vaults for safekeeping. Fractional reserve banks, by definition, issue bank notes and/or deposits as a multiple of whatever is counted as the currency on reserve in bank vaults, teller draws, and modern cash dispensing machines.

Why do banks issue deposits as a multiple of currency on reserve? The commercial customs, rules of law, and double-entry accounting scheme make it profitable to do so in the short run and government subsidies extend profits to the long run.

An individual bank holds a mix of loans, reserves, and securities on the asset side of the balance sheet. The bank issues liabilities and equity where assets must equal liabilities plus equity under the legal rules and methods of double-entry accounting. Transaction deposits are liabilities of banks which non-banks use to make customary payments, so the loan is an increase of bank assets and transaction deposits are the increase of liabilities in the bank system. Next each bank may have to send payment to another bank. This is a transfer of deposits on the liability side and reserves on the asset side in the accounting customs for clearing interbank payments. The only thing that happens when banks clear the check or an electronic payment authorization is an adjustment on the books of each bank is made and an adjustment on the records of the non-bank payor and payee is made to reflect the "transfer" of deposits, for non-banks, and of deposits and reserves, for banks.

If a bank cannot force a flow of reserves in its favor, via the issue of interest bearing deposits or shares that pay dividends, then it will be forced to sell securities out of its liquidity cushion, and then it will be forced to liquidate its loan portfolio, to keep making interbank payments. So the banking sector must increase the sum of deposit liabilities, money market borrowings, and equity to expand its portfolio of loans and securities. An efficient banking system can do this on a very tiny amount of reserves but eventually there is a shock in the wholesale money markets and a banking panic usually ensues. This is when some banks will be unable to rollover their deposits and other money market borrowings as these mature, and will be unable to issue new equity, because investors do not want to put risk money into a failing bank.

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Payments Settlement, Network Effects, Free Money

To understand the motivation for retail banking clients, it helps to think not about the process of issuing a loan, but first, the process of spending it. Imagine that Alice has just received a loan for \$10,000 from Acme bank. She uses \$8,000 to purchase a used commercial oven for her bakery, from private seller Bob, who banks at FizzBuzz. Alice writes a check and gives it to Bob, who both delivers the oven and deposits the check at his bank.

Now, there are many check clearinghouses and payment settlement systems, but one of them is the Federal Reserve (in the US...other countries have a corresponding central bank that plays a parallel role). Let's suppose the check makes its way there for clearance and settlement. The Fed determines that the check is legitimate, and moves funds between Acme and FizzBuzz. In particular, both banks have an account at the Fed (which is a bank for banks...the central bank is a bank whose customers are themselves banks or the national treasury). It thus debits \$8,000 from Acme's account, and credits the same to FizzBuzz's account. Assuming that Acme is not overdrawn, the transaction completes and all is well.

But what happens if a lot of Acme customers had written checks recently, and all of them just happened to get cashed (deposited, settled, etc.) today? Well, it turns out that Acme can overdraw its account! And when that happens, the Fed allows it, but forces Acme to borrow the balance via the overnight Fed Funds mechanism. That is, they get a one-day loan to balance their Fed account at whatever interest rate is set by the Fed (one of the mechanisms the Fed uses to influence economic activity). The next day, Acme must pay back the loan by depositing the necessary funds into its Fed account, with interest. Don't worry, though! In most cases, Acme's customers will also be receiving checks from other banks, which helps replenish Acme's reserve account with the Fed. As long as Acme retains adequate reserves, it will be on either side of the overnight loan equation about the same amount of the time.

Reserve Requirement

Now, for large banks, the Fed requires, by law, that the bank maintain a minimum balance with the Fed (just like, retail customers with fancy accounts with lots of perks may also be required to maintain a minimum balance). And it turns out that this balance is a fraction of the deposits the bank has on its books (10% is a common number, but some jurisdictions actually have no reserve requirement). And from this, we get the commonly cited claim that banks "loan out the money deposited by bank customers". However, there's a problem here.

First, the Fed doesn't care where the reserves come from. The bank can raise money by issuing stock, selling bonds, selling cupcakes, playing craps at the casino...all the ways that anyone else can raise money (well, within the regulations imposed on banks). So it's entirely possible for a bank to fund its reserve account with money raised entirely in capital markets (that is, from investors, not retail depositors). Indeed, a bank funded this way can issue loans without a single "outside" deposit (meaning, from money which comes from a customer).

Second, note that the reserve does not need to be a constantly growing pool of money. It's primary function is to facilitate inter-bank payments, and it really only needs to be big enough to cover all the outgoing payments drawn against its accounts on any given day, with the stipulation that the reserve will also be replenished by payments arriving into its accounts. On average, the reserve should maintain a somewhat stable size. Frankly, it doesn't really matter if the number and size of deposits is growing or shrinking, as long as the reserve is adequate to cover payments settlement, as well as the Fed reserve requirement (which is mostly just a safety check more than anything).

Third, it should be noted that a the Fed only imposes a reserve requirement on banks with more than $16.3 million in assets. Thus, a small bank literally does not require depositors. And yet, it can still issue loans.

Net Settlement

The Federal Reserve is a bit strict in that it requires all the daily checks flowing from Bank A to Bank B to be handled as one transaction, and all the daily checks flowing from Bank B to Bank A to be handled as another transaction. This artificially inflates the reserve requirements. For this reason, banks often use other settlement systems which have been set up between them (especially regional banks). These systems allow "net settlement", which means that if Acme Bank owes \$25 million in payments to FizzBuzz, but FizzBuzz owes \$29 million to Acme, the settlements system will say: "You can handle the \$25 million in transactions internally. We are only going to create a single payment for \$4 million from FizzBuzz to Acme." Notice how this dramatically lowers the reserve consumption at the central bank. This avoids a significant amount of the overnight borrowing imposed by the Fed, and results in lower fees for the banks.

But wait, there's more! We sort of hand-waved what is going on during net settlement. We know that thousands of checks got drawn against Acme accounts to pay FizzBuzz customers, and vice versa. But what happened to that \$25 million that never actually moved between banks? Well, it's simple. One of those checks is from Alice (Acme) to Bob (FizzBuzz). But another check was written by Darren (FizzBuzz) to Candace (Acme), for \$2,000. Rather than move \$8,000 from Alice's account to FizzBuzz, Acme just moves \$2,000 from Alice's account to Candace's, and then looks for more incoming payments to dispose of the rest of Alice's check. Of course, that's not literally what's happening. In reality, the accounts just get credited and debited as if the proper transaction occurred. But logically, the money to pay Paul comes from Peter, because both Peter and Paul are customers of the same bank, and this avoids intermediation by fee-charging third parties. Of course, the settlement houses still charge fees for their service, so they haven't really gotten away from fees...they have just reduced them by a significant margin.

Now, we get to the coup-de-grace: the "free money". It's actually only one of the free monies. It turns out there's a lot of free money in banking (hence, why it's so popular!). What happens when Candace writes a check to Alice? Since they are both customers of Acme, the check never has to leave the bank! Acme will quite happily settle the check internally, without engaging any third-party settlement service. When this occurs, a bank officer does a little happy dance. And how often does this dance occur? Well, about 30% of the time!

Network Effects

By this point, I hope it is obvious why banks want retail customers: when both the payer and the payee are customers of the bank, the bank saves money processing the transaction. This is especially true when a bank customer receives a loan from the bank, and "spends" it at that bank (by purchasing goods and services from other customers of the bank). The more customers use the same bank, the more the bank can lower its fees and raise its savings rates. This is the "network effect" which drives customer-seeking. Remember, when a customer makes a transaction with another bank, both banks pay fees to a third party to process the transaction. If the reserve is exhausted, they pay even bigger fees for overnight funds. So, keeping transactions "in-house" is extremely attractive and financially lucrative for banks. Every bank thus seeks to obtain every possible bank customer, just as corporations generally seek to obtain a monopoly to maximize their profits.

Overnight Funds

Of course, the sequence of payments is a more or less random process, as far as the bank is concerned. It cannot control when its customers write or deposit checks and other payments. On any given day, the transactions will mostly balance and no overnight funds will be required. However, when funds are required (due to an unlucky series of outflowing payments without a balancing inflow), the bank has to somehow raise money. Of course, there's lots of ways a bank can do this. It can sell liquid assets it has on hand. It can take a short-term loan. It can issue CDs, etc. But why bother with all that hassle when it is sitting on a huge pile of "free money"? That's right, I'm talking about customer deposits. Since a majority of checking accounts have zero or close-to-zero interest rates, this is literally the cheapest temporary money a bank can obtain. In most cases, it doesn't need the money for more than a day or two. It just smooths out the blips in the random sequence of payments between banks.

So you see, the deposits don't facilitate the origination of loans; they facilitate the efficient transfer of payments between banks (of which the majority of money happened to come from a loan, but that's incidental, rather than a necessary requirement).

Money Creation

Now, this question arose from an investigation about money creation, so I think it is worthwhile to consider that question briefly. First, we must consider the nature of a deposit account. When a customer deposits money into an account, they give up legal claim to that money. What they gain is a promise from the bank to return any portion of the money up to the account balance, upon demand. Basically, a deposit account at a bank is a kind of instant loan issued by the customer to the bank, with an indefinite, variable period and an absurdly low interest rate, callable at any time (within the restrictions set out in the account agreement...for savings accounts, there is a maximum number of withdrawals per time period). Of course, the customer wants to issue this loan because the bank will facilitate payments to third parties.

The important fact to note is that, as far as the bank is concerned, a deposit account is a liability. It is something they owe. When money flows into such an account, the liabilities of the bank increase by the amount of the deposit, but so do the assets. The bank now receives the deposit as cash (quite literally, a credit to the "Cash Account", if you like), to spend as it sees fit. As noted above, one of the important ways it spends the deposit is as a short-term cover for payments settlement. But what about loan origination?

When the bank issues a loan, it "deposits" (credits) the loan amount into the customer's deposit account. It then debits the customer's loan account, which is an asset of the bank (it's money owed to the bank in the future). Some folks have implied that this proves that customer deposits fund the loans, but no such thing has occurred. You see, if customer deposits were used to "pay for" the loan, then one more entry would be added: a debit to the bank's "Cash Account". In this case, the actual money that the bank received from customers would be used to fund the loan. But no such transaction is recorded! That is the important point made by the article you cited.

In fact, what has actually happened is that the bank has created an "IOU" and handed it to the loan borrower. The borrower can then spend this IOU as if it were real money, because our legal and financial system says that it is real money. But the reality is, this money was created in the instant that the bank credited the customer's deposit account, without debiting any corresponding cash account. As it turns out, when the customer pays down the loan, payments will then "destroy" the money created by the loan, as they cancel out.

Time Travel

While the money creation/destruction model works just fine for describing what happens in loan origination, there is an alternative way to view the situation which I would like to share. If you were paying close attention, you would notice a small sleight of hand I used in the description above. I said that money creation occurred because the bank credited the borrower's account without debiting a "cash account". But the bank didn't "cheat". It did debit an account: the borrower's loan account. Of course, a loan account is like the inverse of a deposit account: the bank is the one which gets to demand money, up to the amount of the loan. Of course, they are not perfectly symmetrical, but they are sufficiently symmetrical to balance the books. So the money to pay for the loan came from somewhere...not the other depositors, but definitely from somewhere...but where? Well, it should be obvious: it came from the future! After all, that's where the loan account dollars flow into the bank. A bank loan is a time travel device which transports future dollars into the present for use by bank customers! And, just as time loops violate causality and allow a person to be their own grandpa, a dollar in a time loop may also violate causality and become its own "grandpa".

A time traveler which creates himself violates conservation of energy laws because the mass of the time traveler is removed from his future when he travels back to the past, and is added to the past, which is now "heavier" than the previous past by the amount of the time traveler. The duration in which the self-created time traveler exists causes the universe to be "fatter" by the mass of that person. In the same way, the money supply of a universe with time travel is not conserved. The duration in which a money time loop exists (i.e., a loan) causes the money supply to be larger by the amount of the loan. This, IMO, is the best way to see that a loan truly, literally, creates money out of thin air.

Now, we have a problem. What if the borrower breaks the time loop? What if the loan payments do not ultimately destroy the loan, and the borrower defaults? Will this cause a rip in the fabric of spacetime? Well, yes, of course it does! This is why banks demand collateral: the bank tries to repair the rip any way it can, including taking property that has nothing to do with the loan, and using it to patch the rip.

Reification

If the money was created out of thin air, why is it such a big deal for loans to be repaid? Can't we just say: "Oh, it's ok, that was just made-up money anyway. No loss"? Well, yes and no. There are two major problems with loan defaults. The first one is obvious: banks make revenue on loans. Banks are not charities run by volunteers. They are profit-making institutions run by people who expect to be (highly) compensated. And the operating expenses of the bank are generally paid by the interest earned on loans. So, a failing loan == failing revenue == operational shortfall. Bad News.

The other problem has to do with inter-bank payments. If a borrower and all her payees are customers of the same bank, the IOU which is the loan can exist as a kind of magical play money that bankers are allowed to manifest at will. Moving this money between customer accounts just amounts to credits and debits in the accounts on the books. That's because when the borrower says: "I'm cashing in part of this IOU", the bank says: "No problem, the person you're paying is also my customer, so this becomes a kind of IOMe." The problem is when a payment goes outside the bank. At this point, "real money" must exist to cover the payment, and that money must exist in the Fed account for the bank. It is at this point that the "play money" created out of thin air by the loan origination process becomes "real money". I call this process "reification" (but nobody else does). The problem should be obvious: just because Acme bank declares: "This new money exists. I say so." does not mean that FizzBuzz is obliged to recognize that statement when processing a payment. FizzBuzz says: "Nuh-uh. Don't give me that monopoly money. Give me the real stuff!" This is why the Federal Reserve account must be funded with "real money". Otherwise, banks would just always declare that they have the money needed to cover their payments, and never borrow from anyone. Essentially, they would print money indefinitely, and with reckless abandon.

In this narrow sense, the depositor funds play a role. They provide the cold, hard cash money to facilitate the payments between banks, when a borrower tries to spend the newly minted money somewhere else. The depositor dollar "reifies" the future dollar manifested by the loan and spent outside the bank. It becomes the "physical" stand-in for that future dollar that will (hopefully) eventually land on the bank's books. And it is only in this sense that depositor funds are "necessary" for loan origination. However, recall that the reserve account need not be funded by deposits, and thus, deposits only reduce the cost of payments settlement.

Of course, this only works because a bank, on average, has as many payments coming in to the bank as going out. If a bank issues loans, but has no customers who receive payments from other banks, then the bank is clearly going to have a liquidity problem in short order. By acquiring retail depositors, a bank helps ensure the balanced bidirectional flow of funds with other banks. The more balanced the flow, the less reserve required at the Fed. This is the essential role of depositors, and why they are absolutely essential to a bank which issues loans. When a borrower spends a loaned amount, that money becomes a deposit somewhere else, as it flows out of the bank. In order to minimize the amount of base money required by the bank, the bank wants to be a target of loan spending as much as it is a source. Thus, it wants lots of depositors receiving payments from other banks. The netting process causes most of these payments to stay "in-house", with far fewer dollars being "reified" by the Fed account. It is much less concerned with literal cash deposits, which are mostly a rounding error.

Note that all of the money could, in theory, come from loans, with nobody actually depositing M1 into any of the banks at any time! If payments between banks are perfectly balanced, then no reserve is required, either. All the money moving between customers could theoretically be loan-originated money with no currency or M1 involved at all. This is why "broad money" is such an important category in macroeconomics.

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Banks like taking deposits because they can usually pay sub market interest rates on them, hence they can make a profit. For example , if Fed Funds =2pct they might pay 1.5pct on deposits whilst investing the money at 2pct or greater. Things get complicated when Fed Funds gets close to zero (like now). Big banks generally pay close to zero on deposits right now but they can’t earn much with the money either.

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  • $\begingroup$ Yes, but why do banks want the deposits in the first place? Having deposits means that the bank has to pay interest to the depositors (even if the rates are "sub market interest rates"). If banks do not need deposits to make loans, why do they take deposits? $\endgroup$ – Flux Aug 17 at 2:09
  • $\begingroup$ @Flux the answer says: because they make money on them. Borrowing money at low interest rates and lending it out at high interest rates makes money, does it not? $\endgroup$ – user253751 Aug 17 at 9:40
  • $\begingroup$ @user253751 But what is the use of borrowing when they do not need to? $\endgroup$ – Flux Aug 17 at 9:45
  • $\begingroup$ @Flux so they can make extra money? Why does the cake shop also sell biscuits if it can already make money by selling cakes? Well, it makes more money if it sells biscuits too. $\endgroup$ – user253751 Aug 17 at 10:16
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    $\begingroup$ @user253751 Here is what I think Flux is getting at: You referred to "Borrowing money at low interest rates and lending it out at high interest rates" -- the very wording presumes that the borrowing enables the lending, i.e., the money (it) that's lent wouldn't be available without having been borrowed first. But Flux's question is based on challenging precisely this presumption. If the bank can lend money at will, without having to borrow it from depositors, then the bank could make more money by lending and not borrowing. You may disagree, but this where Flux is coming from. $\endgroup$ – nanoman Aug 17 at 21:40

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