Professional Documents
Culture Documents
Why Banks Don't Need Your Money To Make Loans
Why Banks Don't Need Your Money To Make Loans
PERSONAL FINANCE
BANKING
Reviewed by
KHADIJA KHARTIT
Fact checked by
KIRSTEN ROHRS SCHMITT
TABLE OF CONTENTS
How It Works
Banks in the Real World
What Really Affects Banks’ Ability to Lend
The Bottom Line
EXPAND +
https://www.investopedia.com/articles/investing/022416/why-banks-dont-need-your-money-make-loans.asp 1/10
12/17/21, 12:24 AM Why Banks Don't Need Your Money to Make Loans
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.
Advertisement
https://www.investopedia.com/articles/investing/022416/why-banks-dont-need-your-money-make-loans.asp 2/10
12/17/21, 12:24 AM Why Banks Don't Need Your Money to Make Loans
KEY TAKEAWAYS
Banks are thought of as financial intermediaries that connect savers and borrowers.
However, banks actually rely on a fractional reserve banking system whereby banks
can lend more than the number of actual deposits on hand.
This leads to a money multiplier effect. If, for example, the amount of reserves held by
a bank is 10%, then loans can multiply money by up to 10x.
How It Works
According to the above portrayal, the lending capacity of a bank is limited by the magnitude of
their customers’ deposits. In order to lend out more, a bank must secure new deposits by
attracting more customers. Without deposits, there would be no loans, or in other words,
deposits create loans.
Advertisement
https://www.investopedia.com/articles/investing/022416/why-banks-dont-need-your-money-make-loans.asp 3/10
12/17/21, 12:24 AM Why Banks Don't Need Your Money to Make Loans
Of course, this story of bank lending is usually supplemented by the money multiplier theory
that is consistent with what is known as fractional reserve banking.
SPONSORED
BY
MFS
In a fractional reserve system, only a fraction of a bank’s deposits needs to be held in cash or
in a commercial bank’s deposit account at the central bank. The magnitude of this fraction is
specified by the reserve requirement, the reciprocal of which indicates the multiple of
reserves that banks are able to lend out. If the reserve requirement is 10% (i.e., 0.1) then the
multiplier is 10, meaning banks are able to lend out 10 times more than their reserves.
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
https://www.investopedia.com/articles/investing/022416/why-banks-dont-need-your-money-make-loans.asp 4/10
12/17/21, 12:24 AM Why Banks Don't Need Your Money to Make Loans
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.
FAST FACT
In March 2020, the Board of Governors of the Federal Reserve System reduced
reserve requirement ratios to 0%, effectively eliminating them for all depository
institutions. [1]
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. 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.
Now, this may seem a bit shocking since, if loans create deposits, private banks are creators of
money. But you might be asking, "Isn’t the creation of money the central banks’ sole right and
responsibility?" Well, if you believe that the reserve requirement is a binding constraint on
banks’ ability to lend then yes, in a certain way banks cannot create money without the
central bank either relaxing the reserve requirement or increasing the number of reserves in
the banking system.
The truth, however, is that the reserve requirement does not act as a binding constraint on
banks’ ability to lend and consequently their ability to create money. The reality is that banks
first extend loans and then look for the required reserves later.
https://www.investopedia.com/articles/investing/022416/why-banks-dont-need-your-money-make-loans.asp 5/10
12/17/21, 12:24 AM Why Banks Don't Need Your Money to Make Loans
Important: Fractional reserve banking is effective, but can also fail. During a "bank
run," depositors all at once demand their money, which exceeds the amount of
reserves on hand, leading to a potential bank failure.
The mention of risk brings us to the second, albeit related, answer to our question. 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. [3]
Subjective judgment combined with ever-increasing profit-hungriness may lead some banks
to underestimate the riskiness of their assets. Thus, even with regulatory capital
requirements, there remains a significant amount of flexibility in the constraint imposed on
banks’ ability to lend.
Attracting new customers is one way, if not the cheapest way, to secure those reserves.
Indeed, the current targeted fed funds rate—the rate at which banks borrow from each other—
is 0% to 0.25% as of June 16, 2021, well above the 0.01% interest rate the Bank of America
pays on a standard savings account. [5] [6] The banks don’t need your money; it’s just cheaper
for them to borrow from you than it is to borrow from other banks.
Getting the most from your credit card starts with choosing the one that suits your needs.
With
Bank of America, you can compare features and benefits
of different cards, and select the one
that's right for you. Whether you're looking for customized cash rewards or travel rewards,
Bank
of America offers a variety of options to choose from. Learn more
about Bank of America's credit
card offers and apply now.
ARTICLE SOURCES
Related Articles
GOVERNMENT & POLICY
How Must Banks Use the Deposit Multiplier When
https://www.investopedia.com/articles/investing/022416/why-banks-dont-need-your-money-make-loans.asp 7/10
12/17/21, 12:24 AM Why Banks Don't Need Your Money to Make Loans
INTERNATIONAL MARKETS
Who Decides to Print Money in Canada?
FEDERAL RESERVE
How Does Monetary Policy Influence Inflation?
FEDERAL RESERVE
What happens if the Federal Reserve lowers the reserve
ratio?
FEDERAL RESERVE
How Banks Set Interest Rates on Your Loans
FEDERAL RESERVE
Why do commercial banks borrow from the Federal
Reserve?
https://www.investopedia.com/articles/investing/022416/why-banks-dont-need-your-money-make-loans.asp 8/10
12/17/21, 12:24 AM Why Banks Don't Need Your Money to Make Loans
Partner Links
Related Terms
What Is the Key Rate?
The key rate is a benchmark interest rate that determines bank lending rates and the cost of credit for
borrowers.
more
https://www.investopedia.com/articles/investing/022416/why-banks-dont-need-your-money-make-loans.asp 9/10
12/17/21, 12:24 AM Why Banks Don't Need Your Money to Make Loans
TRUSTe
Advertise News
https://www.investopedia.com/articles/investing/022416/why-banks-dont-need-your-money-make-loans.asp 10/10