Let’s assume that you and I create a company that provides two services:
a) hold money for other individuals and provide a small interest rate of 2%.
b) provide loans to other individuals who want to buy an apartment or house.
We are lucky, and via our network, we managed to attract five high-net-worth individuals who each decided to deposit to our company 100 thousand euros. That means that we are holding funds of 500 thousand euros.
The law requires us to keep 10% of the 500 thousand euros as ‘reserves.’ That means we need to keep 100 thousand euros, but we can lend the 400 thousand euros.
We promote our services, attracting two individuals who want 200 thousand euros each to buy a house. We provide these individuals a loan of 200 thousand euros each at a 5% interest rate. That is very good for us as we provide an interest rate on our 500 thousand euro depositors of 2%, but we make 5% on the money we lend.
I don’t know if you realized it, but we created money. That money doesn’t exist. The 400 thousand euros is money owed to the high net-worth individuals who deposited them to our company. They might need this money tomorrow, but we just used it to lend to the two customers who used it to buy houses. In plain terms, if our company is the only one in our country holding money and providing loans, before we provided the loans, there were 500 thousand euros in the market. There are now 900 thousand euros in the market: 500 thousand euros in deposits and 400 thousand euros in loans.
Of course, you guessed it. I described a simplified version of a modern bank. The system they use to operate in such a way is called the Fractional Reserve Banking, which arguably has pros and cons. Most people do not realize that banks actually use their savings in such a way. Digitally, they might appear on your screen as if they’re there, but in principle, they are used to create money, and the amount of physical cash available is extremely low. Looking at the US, macroeconomist Lyn Alden did the math: “To quantify it, US banks have $17.6 trillion in deposits, of which $3.1 trillion is backed up by cash, of which less than $100 billion ($0.1 trillion) is backed up by physical cash.”
Interesting, right?
