How Banks Work

We’re all familiar with banks but does the average person understand how they work? Banks act as a secure place for people to store their money. They also lend money to people who need more funds than they already have stored in their bank. What’s interesting is that banks create money from thin air. Let’s explore how that works. But first let’s talk about the money supply.

The money supply is the sum of all currency and other liquid instruments in a country’s economy as of a specific time. There are specific designations of money. M1 money is cash and also known as narrow money. M2 includes M1 plus traveler’s checks and demand deposits and is considered the beginning of broad money. M3 includes M2 plus savings deposits, and money market deposits.

How does a bank increase the money supply? By lending. The Federal Reserve is responsible for overseeing all banking operations in the country and they specific terms and conditions. One of those rules governs the reserve requirement. This is the amount of funds that a bank must hold in reserve to meet the demands of sudden withdrawals. An extreme version is called a run on the bank, where large groups of depositors withdraw their money simultaneously on the basis of fear. The reserve requirement specifies an amount that must be available from each institution but let’s consider the value as a percentage to explore its role in increasing the money supply.

Assume we have a 10% reserve requirement where a bank must retain or hold in reserve 10% of all deposits. A new customer deposits $1000 into their savings account. The bank must reserve $100 but can now lend the rest to other people effectively creating an additional $900 of new money. The bank now has the original $1000 of the deposited savings account and it has an additional $900 on the books as an asset. A loan is an asset to the bank since the borrower pays the cost of borrowing as interest on the loan. The bank uses the interest paid on the loan to pay its employees and pay its depositors for the use of their money in deposit.

Banks make their money by managing your money. They collect interest from lending and they also collect fees by providing services like funds transfer and other monetary conveniences. They also charge fees to originate loans which is typical in mortgage operations. There are many types of banks in operation. The government itself operates the central bank. They are responsible for managing the money supply and setting monetary policy. They essentially act as the lender of last resort. The Federal Reserve doesn’t lend to individuals but instead to other banks. Individuals experience the Retail Bank, these entities offer loans and deposit accounts to individuals and businesses. Adjacent to this space is Savings and Loan association and Credit Unions also very common option for individuals. Where as Commercial Bank only offer services to businesses and corporations. Commercial lending is typically on a bigger scale than Retail. There are also Investment Banks who cater to securities trading and wealth management. They also assist with underwriting of loans, organizing an IPO, facilitate M&A activities. Lastly there are Shadow Banks, these aren’t really banks but instead organizations making investments in credit and debt instruments. Insurance companies and hedge funds are examples of Shadow Banking entities.

These banking entities are the primary drivers of growth in the money supply but there is another way. The Federal Reserve can “Print” more money by engaging in quantitative easing (QE). During a QE phase the Feb will buy assets from the open market using money created from nothing. Congress also creates money through funding bills like the CARES act. Increasing the money supply also increases inflation but not at a consistent rate. We can explore inflation next.