12/17/21, 12:24 AM Why Banks Don't Need Your Money to Make Loans

PERSONAL FINANCE

BANKING

Why Banks Don't Need Your Money to Make

Loans
By
MATTHEW JOHNSTON
Updated May 30, 2021

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 +

Traditional introductory economic textbooks generally treat banks as financial intermediaries,

the role of which is to connect borrowers with savers, facilitating their interactions by acting
as credible middlemen.
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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.

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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.

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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.

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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
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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] 

Banks in the Real World

In today’s modern economy most money takes the form of deposits, but rather than being
created by a group of savers entrusting the bank withholding their money, deposits are
actually created when banks extend credit (i.e., create new loans). As Joseph Schumpeter
once wrote, “It is much more realistic to say that the banks 'create credit,' that is, that they
create deposits in their act of lending than to say that they lend the deposits that have been
entrusted to them.” [2]

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.

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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.

What Really Affects Banks’ Ability to Lend

So if bank lending is not restricted by the reserve requirement then do banks face any
constraint at all? There are two sorts of answers to this question, but they are related. The first
answer is that banks are limited by profitability considerations; that is, given a certain demand
for loans, banks base their lending decisions on their perception of the risk-return trade-offs,
not reserve requirements.

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]

If bank lending is constrained by anything at all, it is capital requirements, not reserve

requirements. However, since capital requirements are specified as a ratio whose
denominator consists of risk-weighted assets (RWAs), they are dependent on how risk is
measured, which in turn is dependent on the subjective human judgment. [4]

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.

The Bottom Line

Expectations of profitability, then, remain one of the leading constraints on banks’ ability, or
better, willingness, to lend. And it is for this reason that although banks don’t need your
money, they do want your money. As noted above, banks lend first and look for reserves later,
but they do look for the reserves.
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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.

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ARTICLE SOURCES

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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

Why Bank Reserves Matter

Bank reserves are the cash minimums financial institutions must retain to meet central bank
requirements. Read how bank reserves impact the economy.
more

Understanding Commercial Banks

A commercial bank is a financial institution that accepts deposits, offers checking and savings account
services, and makes loans.
more

Whar Are Bills Payable?

Bills payable is a synonym of accounts payable, or short-term borrowing by banks from other banks.
more

What Is a Reservable Deposit?

Reservable deposits, like transaction accounts, savings accounts, and non-personal time deposits, are
subject to Federal Reserve reserve requirements.
more

Federal Funds Definition

Federal funds are excess reserves that commercial banks deposit at regional Federal Reserve banks which
can then be lent to other commercial banks.
more

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