Different countries throughout the world use different banking systems. There are differences based on government structure, levels of industrialization, degree of globalization, culture, and religion.
Banking systems have been undergoing many major changes in recent years. New technologies are being used. International banking is growing and evolving. Global currencies, such as the U.S. dollar and the Euro, have increasingly influenced world banking operations. Even within the United States, a relaxation of banking regulations is changing the fundamental ways that the banking system operates.
The purpose here is not to provide details of all of these differences and changes. Instead, the focus is on one of the basics of the United States Banking system: How commercial banks create money.
Banks act as financial intermediaries. They use funds deposited by savers to make loans to borrowers. Banks make profit from this activity. They charge a higher interest rate to borrowers than they pay to savers.
In the United States, the Federal Reserve System (The Fed) supervises commercial banks. The Fed sets rules for commercial banks based on the Fed's monetary policy.
In addition, the Fed provides services to commercial banks. The Fed provides currency for banks, makes loans to banks, holds reserves for banks, and clears checks between banks.
The Fed has been called a banker's bank because of these services.
How Banks Create Money
When people deposit money in a commercial bank in the United States, the amount deposited remains part of the U.S. money supply. Checking accounts are part of the M-1 definition of money. Savings accounts are generally considered to be part of the M-2 definition of money.
Depositors can withdraw their funds on demand. This creates an equal liability for the banks. The funds that the banks accept in deposits belong to the depositors. For the banks, the deposits are reserves.
On a typical day, only a very small fraction of the deposits in a bank will be needed to meet the demand for withdrawals. The bank will attempt to keep enough currency on hand to meet the demand for currency transactions. The rest of the deposits are kept at the Fed for safekeeping.
It is not profitable for banks to have a lot of reserves sitting around, not earning income. So banks loan out the reserves to borrowers and charge interest on the loans. These loans decrease the amount of reserves for the banks.
The banks cannot loan out all of the money that is deposited. They must keep enough reserves on hand to meet the daily needs for withdrawals.
The Fed determines the level of reserves that banks are required to hold. This level is a percentage of total deposits. This level is called the required reserve ratio, or the reserve requirement. The Fed determines the level to set the reserve requirement based on monetary policy. Since this ratio will help determine the size of the money supply, the reserve requirement becomes a tool that the Fed uses in its monetary policy.
Since banks cannot loan out 100% of its reserves, this type of banking system is called a fractional reserve system. The reserves for an individual bank above the reserve requirement are called excess reserves. An individual commercial bank is allowed to loan out money as long as it has excess reserves.
When a bank makes a loan from its excess reserves, it typically will credit funds to the borrower's account, which is part of the money supply. The reserves that provided the loan, however, are still counted as deposits in other customers' accounts, which are also part of the money supply. So when banks make loans, they increase the money supply. Money is created "out of thin air".
Amount of the deposit times (1 minus the reserve requirement)
Relatively widespread misconceptions exist about the amount of this expansion of the money supply, so I will clarify with an example. If the reserve requirement is 10%, then banks will be allowed to loan out, in total, an amount equal to $90 for every $100 dollars on deposit. This would be $100 times (1 - 0.1), the formula above using the numbers from the example. Many people incorrectly believe that a bank with a 10% reserve requirement can loan out 10 times the amount of the deposit, or $1000 for every $100 on deposit. This greatly overstates the ability of an individual bank to increase the money supply, and the effects of the fractional reserve system on the overall economy. However, that is for individual banks. The banking system as a whole does have a theoretical ability of increasing the money supply ten-fold with a 10% reserve requirement.
When an individual bank makes a loan from excess reserves, it sets off a chain of events throughout the entire banking system, which multiplies the amount of money that eventually can be created out of that initial transaction.
Deposit Expansion Multiplier
The money supply in the entire economy, in the entire banking system, can expand by more than the amount created by an initial deposit in an individual bank. A typical borrower does not borrow money and then leave it sitting in a bank account. The borrowed money is spent in the economy. This becomes income for somebody else. To the extent that it is then redeposited into an account at a different commercial bank within the banking system, reserves are created at that other bank. The other bank can, in turn, loan out its excess reserves. This process then can repeat itself continuously, increasing the money supply with every additional loan.
The maximum amount that an initial deposit can increase the money supply within the entire banking system is given by the formula:
In the above example, an initial deposit of $100 with a 10% reserve requirement allowed an individual bank to increase the money supply by $90. If you apply that same $100 deposit to the deposit expansion multiplier, the entire banking system would be able to increase the money supply by $1000 ($100 initial deposit times the deposit expansion multiplier, which is 1 / 0.1).
Economics classes in money & banking and macroeconomics often require students to be able to make calculations based on this formula. Keep in mind, however, that this formula is only a mathematical maximum. The actual amount of money that would be created within a real world banking system would be somewhat less than the maximum amount.
The reason why the real world expansion of the money supply would be less than the mathematical maximum calculated using the deposit expansion multiplier formula: It is not realistic to assume that every individual bank would always keep its excess reserves at exactly zero. Doing so would be required for the money supply to increase by the maximum amount. Not all loan proceeds are deposited in the borrowers' accounts, although most would be. When these loan proceeds are spent, they do not always end up as deposits in another bank. Also, excess reserves at a given bank are not only increased by deposits, they are also decreased by withdrawals.