Personal Finance

The Bank Deposit and Lending System – What You Need To Know

bank deposit and lending system

Did you know that most of the money in the world isn’t intangible? Only a minuscule fraction of money that is actually tangible exists in the world. By tangible, I mean money you can feel and touch. If everyone in the world pooled together all of the paper money and coins in their possession, it would still be a fraction of the money that exists digitally in the world. In fact, banks create about 97% of the money in the world via the depositing and lending system.

Most of the money in the world exists on bank ledgers and in digital accounts. Governments create only about 3% of the money in the world. Imagine collecting all of the tangible paper money and coins together and counting its value. That might equal about $1.5 trillion. That sounds like a lot but let’s now collect all the tangible money in the world. If we did that, it would probably equal about $5 trillion. However, all of the intangible and digitized money in the world would equal about $80 trillion.

Banks Make Most Money

The bank deposit and lending system creates most of the money that exists in the world. Contrary to popular belief, money doesn’t just sit in banks all of the time. Federal Reserve fractional reserve requirements determine the amount of monetary supplies stored in a bank. That is usually only about 10% of a deposit. That means that a bank only has to keep 10% of your bank deposit, for example, on hand in a bank vault on the premises. Or in a central bank.

A system of banks perpetually loaning out a percentage of the value of deposits in the form of loans creates money in the world. The bank charges a higher rate of interest on the loan as opposed to the interest on a deposit. The process then keeps repeating itself. When a new customer deposits money, the bank collects the deposit at interest. Then the bank loans out nine dollars out of ten from that deposit in the form of loans at a higher rate of interest.

Why?

Believe or not, this process is exactly how about 97% of all the money in the world is created. Why is money created in this manner? The belief is that money created via bank loans, sourced by your deposits, will go out in the economy and then become deposited into another bank. This self-perpetuating process keeps creating money and fueling the economy. Meanwhile, if you loan money from one bank into the community, it flows back into banks as loan payments. Or other banks as new deposits.

Let’s use another example. The Federal Reserve fractional reserve requirement is 10%. A bank receives $100 from you in a new deposit. Your money is added to a pool of deposits the bank collects from other customers. The bank only has to keep 10% of your deposit on the premises, in a central bank or another bank. That means that $90 out of every $100 from every deposit is loaned out to the community. Such bank loans can be used to start a business. Buy a home. Or finance academic scholarships in the community.

It’s Your System

This is an imperfect system. For one thing, there is never enough money on hand to service everyone at the same time. If everyone in the world went to their bank right now and withdrew their money (a legal right) there wouldn’t be enough money in the banks to do so. The Federal Deposit Insurance Corporation insures your deposit up to a quarter million dollars.

That isn’t a lot of comfort if you are trying to withdraw a million dollars from an insolvent bank. The banking, deposit and lending system of the world is imperfect and fragile. But it’s your system and you should know how it works.

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