How Banks Create MoneyWe always hear that banks create money and a banker with a magic wand and a hat comes to mind. What is not so far from reality, in addition, not only is this how banks create money, they also do something similar to what Jesus Christ did with the loaves and fishes, that is, from a few to make many.
The money that exists today in our societies can be divided into two types: on the one hand there is cash (physical money made up of bills and coins), and bank money (digital annotations like the ones we see in our account from the bank).
Cash (coins and bills) can only be created by the official institution in charge of it, the central bank. Bank money, on the other hand, can be created by the same institution that makes banknotes and coins, but also –and above all– by private banks. Thanks to their privileged condition of creating money through the issuance of their debt in the form of deposits, when they lend money to an individual they begin a circle of money creation, accelerated by the multiplier effect of money.
How do they create it?
In order for banks to obtain liquidity, the country's central bank lends them money. And what is the central bank based on to lend you that money? Basically in the long-term investments of the commercial bank. For example, if a bank lends 200,000 euros for a mortgage (which is a bank investment), the central bank lends that bank approximately 200,000 euros, creating that money (electronically "printed"). And in addition, the central bank will refinance the bank in the short term as many times as necessary until that mortgage is paid by the mortgaged.
Once the money is in the hands of the citizens, the banks can also multiply it. We are going to see a simple example of how banks multiply money, illustrating how in an imaginary economy, banks receive € 1,000 and convert them into more than € 90,000:
1. Pepe collects his payroll and deposits € 1,000 in Bank A.
2. Bank A is obliged by law to maintain a percentage of that deposit in the bank's liquid reserves, once deposited it can lend the rest of the money.
The percentage I'm talking about is called the cash ratio. In the euro area, for example, the percentage ranges between 0 and 1%. In the example we are going to use 1%. The lower this percentage, the higher the money multiplier.
Then in Bank A they save 1% of that deposit in their reserves, that is, they save € 10 and lend the remaining € 990 to a second person (Fulanito).
3. Fulanito buys a motorbike from a third person (María) for 900 euros, keeping him with 90 € for his business.
4. Maria keeps that € 900 in bank A.
5. Bank A keeps the € 9 that it has to deposit in reserves by law and lends Carmen € 891.
6. Carmen decides to leave that € 891 in bank B.
We are going to see how much money there is now in this economy, not counting the money that is in the banks' reserves.
Pepe has € 1,000 in bank A.
Fulanito has € 90 in his drawer at home.
María has € 900 in bank B.
Carmen has € 891 in Bank C.
Right now there is a total of € 2,881 in the economy. The banks have created 1,881 euros of the € 1,000 that Pepe entered.
If we continue to develop the example and bank C lends Carmen's money and in turn that person deposits it in another bank and so on, assuming that each person withdraws the money from the bank and directly re-enters it in another bank, as they have done. María and Carmen, each loan granted would have the potential to give another small loan (initial loan minus 1%), in an infinite decreasing series and from Carmen's € 891, the banks would create an additional € 88,209 (891 / 0.01 - 891 ).
Money created: 1.881 + 88.209= 90.090 € !!!
Of the 1,000 euros that Pepe entered, the banks have created another € 90,090 that are distributed among many people.
The creation of money by banks is due to the fact that banks do not lend based on the money they have, but on what they will have. In relation to the example, all the money has been created from the 990 euros that bank A has lent to Fulanito and that he has paid to María. Being Fulanito's motorcycle, the only real asset where this money creation is supported.
So we can see how banks multiply money based on debt. This works as long as Fulanito pays his debt, otherwise the process would stop. This is the unpredictable part of the debt-based money creation system.
Graphically it is as follows: