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How Banks Use Your Money To Make New Money

Author: KalindaRoseStevenson,PhD
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Bankers are magicians who know how to create money. In fact, banks are in business to make money. They make money using the deposits of their customers. This is why banks provide bank checking accounts and loans. They need money to make more money. The deposits of customers become the raw materials the banks use to make more money.

At this point, the choice of vocabulary is critical. Banks are not just "earning" money. Banks are actually "creating" new money.

For example: You deposit $100,000 into a one-year Certificate of Deposit at 5% interest. Your money now becomes raw material for bank loans.

The Federal Reserve sets the reserve rate for the bank from 3-10%. A 3% reserve rate means that the bank must keep 3% of the $100,000 on reserve and can loan the remaining 97%. A 10% reserve rate means that the bank must keep 10% of the $100,000 on reserve and can loan the remaining 90%. For our example, let's assume that the reserve rate is 10%. This allows the bank to loan $90,000 of your $100,000 deposit.

This is the point where the bank does its money magic. It makes a $90,000 loan to a borrower. Now, this $90,000 loan goes on the bank's balance sheet as a $90,000 asset. This is the critical point at which the bank creates money out of thin air.

But the process does not stop here. Since the bank now has an asset of $90,000, it can make another loan based on this asset. Since the same Federal Reserve rules apply, the bank must keep 10% of this asset on reserve. This means it can loan only 90% of the $90,000. This means that Loan #2 is $81,000. By creating another loan, the bank has created another asset. The $81,000 loan to the borrower becomes an $81,000 asset for the bank. Once again the bank creates money out of thin air.

And since the bank now has an additional $81,000 asset, it can make another loan. Once again, the bank must keep 10% of this asset on reserve. This means it can loan only 90% of the $81,000 asset. Loan #3 is $72,900.

Even though the Federal Reserve allows banks to make five to six loans based on the original $100,000 deposit, we'll stop at three. Each new loan is a new asset, which means new money for the bank. Let's add up how much new money the bank created.

You deposit $100,000 into a CD. The bank creates three loans based on the original $100,000 deposit. Loan /Asset #1 = $90,000 Loan/Asset #2 = $81,000. Loan/Asset #3 = $72,900. The total = $243,900 in assets for the bank. This is $243,900 in new money.

When you cash out your CD, you get your $100,000 deposit back, in addition to the $5,000 interest. Meanwhile, the bank has created $243,900 of new money. After it pays you 5% interest, the bank has made a tidy profit of $238,900. ($243,900 - $5,000 = $238,900.) If the numbers are confusing, go over them again until you see how magical this process is. This is how banks create money.

The process is not as linear as my example. Banks don't make a series of separate loans based on an original deposit. When you deposit your money into the bank, your money becomes part of a large pool of money, which the bank can use to make loans. But my oversimplified example shows how banks use customer deposits to make money out of thin air. You deposit money, the bank keeps some on reserve, and uses the rest to make loans. The loans become assets, and the assets become new money.

What difference does it make to see how banks use money to create money? You and I can't do what banks do, by loaning on the same money more than once. The real point of this example is to take some of the mystery out of money.

The process a bank uses to create money demonstrates that money is not a commodity in limited supply, where there is only so much to go around. Money is not equivalent to currency. Money is created in money-making transactions, which means there is no potential limit to money.

So, if you want more money, think the way bankers think. Ask how you can use money to create more money. If you really think the way bankers think, you will use someone else's money to create more money. The crucial idea behind all of this is: The greatest limit to money is the belief that money is limited.

About the Author

Kalinda Rose Stevenson, Ph.D. Learn the difference between earning money and making money in a real estate investing book, "No Money Limits." Go to http://www.NoMoneyLimits.com to get your Free "52 Heart of Money Insights."