The Money Multiplier: How the Banking System Creates Money
Most banks work like this: you deposit money in your bank account, and the bank then lends that money to someone else, with interest.
Banking rules may compel the bank to set aside -- or "reserve" -- a portion of the funds to meet the bank's daily cash needs, to account for depositors who return to the bank to withdraw their money. In the US, this reserve requirement is currently 10%.
This system of banking is called "fractional reserve banking", and because of its design -- where most of a deposit is loaned to someone else -- this system produces a very interesting phenomenon called the "money multiplier" (also called "the multiplier effect").
So say you deposit $100 into your account at a bank working under a 20% reserve requirement.
Of your $100 deposit, $80 would be lent out by your bank; and that amount would likely find its way into another deposit account at another bank. In turn, 80% of that amount could be lent out and find its way into yet another deposit account.
Days after your $100 deposit, a banking system with a 20% reserve requirement could find itself with up to $500 in new money.
The particular reserve requirement has an enormous impact on the ability for the banking system to create money. If banks had a reserve requirement of 10%, then the banking system would be able to turn $100 into $1000.
With a 1% reserve, banks could turn $100 into $10,000.
Reserve Requirements Vary
Each country sets its own reserve requirement. Currently, the requirement set for China is 20.5%, the US is 10%, Russia is 4% and the Eurozone is 1%. The United Kingdom has a voluntary requirement and some countries, including Australia and Canada, have no reserve requirements at all.
Some banking systems make it easy for member banks to meet the reserve requirements. In the US, the 10% requirement is reduced (ie. made easier) for banks having less than $71 million in net transaction accounts; or for deposits owned by foreign corporations or foreign governments. There's no reserve required for CD's and savings deposits owned by entities other than households. And in the US, when a bank has a deficiency, its allowed to borrow funds from another bank with an excess.
Benefits of the Money Multiplier
The money multiplier is a way to leverage capital -- making a lot out of a little -- to the benefit of everyone who benefits from a vibrant economy.
There's a lot of public good that can come from the loans that banks are able to make. This is the working capital that people can use to build business, buy houses and develop roads, bridges, etc. for their communities.
Risks of the Money Multiplier
But the system also has downside risk. It's important that we understand this risk, know how to measure it, and be ready in case it impacts us.
- Withdrawals Exceed Deposits
If you needed to go to your US bank (working on a 10% reserve requirement) and withdraw $100 from your account, the economy would lose close to $1000 in capital. The effect would be that $1000 in loans would need to be called in, and the economy in the meantime would lose the utility of all that money.
Because the system is built on leverage - one dollar supporting many dollars - the multiplier-effect can remove money from the economy just as quickly as it created it.
But withdrawals aren't the only risk...
- Making Bad Loans With Depositors' Money
If your bank couldn't recover the $90 it lent from your $100, then there would be close to $1000 leaving the economy.
- Bank Fraud
Without proper oversight, one bank with dozens of internal accounts could deposit and lend its way to quite a lot of new money in just a few weeks.
- A Deflationary Economy
There's a double-whammy impact on the economy when deflation hits and values are reduced. When the values of people's property goes down, their ability to maintain their loans also goes down. As loans are called in by banks, the money supply could be reduced by tenfold (for US banks), accelerating the downturn.
- Reserve Requirements Set Too Low to Meet Needs
Another risk inherent in the banking system has to do with the main component of the money multiplier: setting a reserve requirement that is too low. With insufficient reserves, a bank could have problems meeting its daily cash needs. If depositors find that they're unable to withdraw funds, a bank would find itself technically bankrupt. A run on a bank could be mitigated with deposit insurance or cooperation from the banking system. But a run on a banking system would be catastrophic.
An interesting aspect of the money multiplier is how it allows a government's treasury department, or a state banking authority, to impact the capital system with relatively small inputs.
In the US, the Treasury Department can borrow funds and lend them, or simply deposit them, into banks. Because of the money multiplier, a 100 billion dollar loan can have a trillion dollar impact on the capital in the US system.
It might be tempting, for example, to use the multiplier to fight deflation. The government could inject money into the economy and then expand that money with the multiplier. But if the core economic issues weren't addressed, this stop-gap solution could lead to bigger problems in the future.
It would be prudent to fully explore the benefits and risks of using such leverage to manipulate economic activities on such a large scale. We should consider the unintended consequences of using this leverage as an economic tool. And we should be aware of the dangers of putting it into the hands of those who might find it self serving.
The bottom line is that the banking system exists because we as citizens have given them the franchise to do so.
We have granted to the banking system the right to create money by way of the money multiplier. In return, society receives a benefit from the capital that the banking system creates.
But we should be aware of the risks that this leveraged system has.
As useful as leverage works when things are moving forward, it can make things more challenging if the economy goes the other way.