How Do Banks Make Money?

In exceptional situations, the central bank may provide funds to cover the short-term shortfall as lender of last resort. In modern economies, the creation of money is inextricably tied up with the creation of credit, or the process of lending by commercial banks whose actions are regulated by government and managed by the central bank.

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. In the case of borrowing and lending, it is often not possible for the lender to write a contract that ensures a loan will be repaid by the borrower . The reason is that it is impossible for the lender to ensure by contract that the borrower will use the funds in a prudent way that will allow repayment according to the terms of the loan. The profitability of the business depends on the difference between the cost of borrowing and the return to lending, taking account of the default rate and the operational costs of screening the loans and running the bank. In the UK, for example, the policy interest rate set by the Bank of England was 0.5% in 2014, but few banks would lend at less than 3%. In emerging economies this gap can be quite large, owing to the uncertain economic environment.

Using The Money Multiplier Formula

Singleton Bank is required by the Federal Reserve to keep 10% of total deposits, or $1 million, on reserve to cover withdrawals. By loaning out the $9 million and charging interest, it will be able to make interest payments to depositors and earn interest income for Singleton Bank and make interest payments to depositors . Instead of becoming just a storage place for deposits, Singleton Bank can become a financial intermediary between savers and borrowers. The key financial ratio used to analyze fractional-reserve banks is the cash reserve ratio, which is the ratio of cash reserves to demand deposits. However, other important financial ratios are also used to analyze the bank’s liquidity, financial strength, profitability etc. The process of fractional-reserve banking expands the money supply of the economy but also increases the risk that a bank cannot meet its depositor withdrawals.

If the central bank raises the policy interest rate, then this will reduce the market price of the bond, increasing the yield in line with the interest rate. Since the central bank controls the supply of base money, it can also decide the interest rate.

Whats A Commercial Bank?

Marco and Julia’s indifference curves and hence their pure impatience are similar. They differ according to their situation, not their preferences. Julia borrows because she is poor in the present, unlike Marco, and that is why she is impatient—she needs to smooth her consumption. Borrowing and lending allow us to rearrange our capacity to buy goods and services across time. Borrowing allows us to buy more now, but constrains us to buy less later. To see how this works, think about Julia, who needs to consume now but has no money today.

Thus, even with regulatory capital requirements, there remains a significant amount of flexibility in the constraint imposed on banks’ ability to lend. 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. Read on to see how banks really use your deposits to make loans and to what extent they need your money to do so. One response of the lender to this conflict of interest is to require the borrower to put some of her wealth into the project . The more of the borrower’s own wealth is invested in the project, the more closely aligned her interests are with those of the lender.

Money can take the form of bank notes, bank deposits, or whatever else one purchases things with. The net worth after consumption in period 1 is –35, which is what she borrowed. She then consumes the $58—it flows out through the bathtub drain, to use our earlier analogy. Since she still has the $58 liability, her net worth falls to –$58. This is recorded in Figure 10.12 in her balance sheet under the heading ‘Now ’. With a higher rate of lending, the feasible frontier becomes steeper, pivoting from the point 100 on the horizontal axis. In particular, the intercept with the vertical axis will be higher than 110.

This is because, unlike the failure of a firm, a banking crisis can bring down the financial system as a whole and threaten the livelihoods of people throughout the economy. In Unit 17 we will see how bank failures were involved in the global financial crisis of 2008. Bonus Bank lends him the money by crediting his bank account with $100, so he is now owed $120. Its assets have grown by the $100 it is owed by Gino, and its liabilities have grown by the $100 it has credited to his bank account, shown in Figure 10.13c. But suppose that, instead of 10%, the interest rate is now 78%, the average rate paid by the farmers in Chambar. At this interest rate Julia can now only borrow a maximum of $56, because at 78% the interest on a loan of $56 is $44, using up all $100 of her future income.

Exercise 10 6 Interest Rates And Consumption Spending

Other businesses sell widgets or services; banks sell money — in the form of loans, certificates of deposit and other financial products. They make money on the interest they charge on loans because that interest is higher than the interest they pay on depositors’ accounts. Invest those funds within the guidelines given by federal and state agencies. Banking institutions are required to maintain reserves up to 10% of their deposits. The remainder is usually invested in real estate loans, commercial and consumer loans, and government securities.

• It is the amount you’d have to put in a bank today in order to have exactly that promised amount when the future arrives.
• Because the nature of fractional-reserve banking involves the possibility of bank runs, central banks have been created throughout the world to address these problems.
• Since 1913 when the Federal Reserve was established, it has never lost a cent on its discount window loans to banks.
• For more on this topic, see “Lending to depository institutions.”
• Draw a set of indifference curves for Julia if she does not experience diminishing marginal returns to consumption and has no pure impatience.
• Bank reserves are held as cash in the bank or as balances in the bank’s account at the central bank.

And when the price of a bond falls, the interest rate rises. The U.S. Federal Government has a very good track record of repaying on its loans. (In part, that’s because U.S. citizens reliably pay their taxes, which provides the money the government needs to repay its debts!) Consequently, the T-Bill rate—the interest rate paid by the U.S. Government for selling Treasury Bills—is sometimes considered to be a risk-free rate of interest. Banks offer their best borrowers a rate that is usually only slightly higher, called the prime rate.

Exercise 10 4 Lifetime Income

It therefore basically, what commercial banks do is to create the money which they lend to borrowers. The money multiplier is a heuristic used to demonstrate the maximum amount of broad money that could be created by commercial banks for a given fixed amount of base money and reserve ratio. This theoretical maximum is never reached, because some eligible reserves are held as cash outside of banks. The proceeds of most bank loans are not in the form of currency. Banks typically make loans by accepting promissory notes in exchange for credits they make to the borrowers’ deposit accounts. Deposits created in this way are sometimes called derivative deposits and are part of the process of creation of money by commercial banks.

The bank pays some of the interest it earns—by lending out your money—directly back to you, the depositor, and takes the rest as payment for its services in matching you up with a borrower. While checking accounts are usually too small and variable for a bank to do this, other kinds of bank accounts such as savings accounts, money market accounts, and certificates of deposit earn interest.

Exercise 10 7 Microfinance And Lending To The Poor

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• We saw that Julia, who will earn $100 in the future, wants to borrow.
• Now, this may seem a bit shocking since, if loans create deposits, private banks are creators of money.
• The banks charge them interest, which they collect as their profit.
• As we mentioned in the previous section, the amount available to lend also depends upon the reserve requirement the Federal Reserve Board has set.
• The new Gini coefficient is 0.70, showing an increase in inequality as the result of the credit market exclusion of the poor.

The boundary of Julia’s feasible set is her feasible frontier, shown for the interest rate of 10%. Although in everyday language this is sometimes referred to as investment, in economics, investment means expenditure on capital goods such as machinery, equipment, and housing.

A risky borrower usually has to pay more interest to convince someone to lend to him or her. In organized markets, the age of the borrower, whether or not the borrower has a steady job, and whether or not the borrower has a history of paying bills on time all factor into the interest rate a lender offers. A few agencies collect these data for individuals and provide summaries, called credit ratings. The riskier a borrower is, the lower his credit rating will be, and the higher the interest rate he or she may have to pay to borrow in organized bond markets. The bond buyers pay now in exchange for promises of future repayment—that is, they are lenders. The bond sellers receive money now and in exchange for their promises of future repayment—that is, they are borrowers.

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. Since the government insures deposit accounts, it is in the government’s best interest to put a damper on excessive risk-taking by banks. For this reason, regulatory capital requirements have been implemented to ensure that banks maintain a certain ratio of capital to existing assets. When a bank makes a loan, there are two corresponding entries that are made on its balance sheet, one on the assets side and one on the liabilities side.

Since net worth is equal to the value of assets minus the value of liabilities, this allows banks to create positive net worth. The capacity of bank lending is not entirely restricted by banks’ ability to attract new deposits, but by the central bank’s monetary policy decisions about whether or not to increase reserves. 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.

In earlier units we saw that giving up free time is a way of getting more goods, or grades, or grain. Now we see that giving up some goods to be enjoyed now will sometimes allow us to have more goods later. The opportunity cost of having more goods now is having fewer goods later. In economics, investment means saving in financial assets such as stocks and bonds. Money is a medium of exchange consisting of bank notes and bank deposits, or anything else that can be used to purchase goods and services, and is accepted as payment because others can use it for the same purpose. Economists talk more often about interest rates than about discount rates. However, in the news you sometimes hear things about how the Fed lowered or raised the Discount Rate.

Money is the cash used as the medium of exchange to purchase goods and services. Because of the loan, the total ‘money’ in the banking system has grown, as Figure 10.13e shows. In practice, banks make many transactions to one another in a given day, most cancelling each other out, and they settle up at the end of each day. So at the end of each day, each bank will transfer or receive the net amount of transactions they have made. This means they do not need to have available the legal tender to cover all transactions or demand for cash.

She knows that in the next period she will have $100 from her paycheck or harvest. Each point in the figure shows a combination of Julia’s capacity to consume things, now and later. We assume that she spends everything that she has, so each point in the figure gives her consumption now and later .

8 Banks, Money, And The Central Bank

As the bank dispute went on, the cheque presented to the pub or shop relied on a lengthening chain of uncleared cheques received by the person or business presenting the cheque. Some cheques circulated many times, endorsed on the back by the pub or shop owner, just like a bank note. Suppose a spate of new ideas spurs an increase in investment. Companies suddenly want to borrow more to develop the new ideas for the future. With more people looking to borrow, it makes economic sense to think that they’d have to pay more to borrow. And sure enough, that intuition is correct—they have to pay a higher interest rate.

Since a borrower is a supplier of bonds, that means the supply of bonds has increased. So, according to economics, the price of bonds should fall. (Bond buyers—lenders—naturally offer only lower bond prices in the face of this increased supply.) So the price of bonds falls.

Banks make profits out of this process by charging interest on the loans. So if Bonus Bank lends Gino the $100 at an interest rate of 10%, then next year the bank’s liabilities have fallen by $10 (the interest paid on the loan, which is a fall in Gino’s deposits). This income for the bank increases its accumulated profits and therefore its net worth by $10.

In the fractional reserve system, just a portion of the overall deposits of the bank has to be held in a deposit account with the central bank or in cash. Interest rate (short-term)The price of borrowing base money.Commercial banks make profits from providing banking services and loans. To run the business, they need to be able to make transactions, for which they need base money. There is no automatic relationship between the amount of base money they require and the amount of lending they do.