Understanding the Mechanics of Bank Lending and the Money Multiplier

Understanding how banks operate is crucial for grasping the concept of bank lending and the significance of the money multiplier.

Banking Basics

In simplified terms, the balance sheet of a bank consists of assets and liabilities. Banks take deposits (liabilities) and use them to make loans (assets). However, the relationship between deposits and loans is not as straightforward as it might appear at first glance.

The Myth of the Money Multiplier

The money multiplier theory suggests that banks can lend more than the money they have on deposit. However, this notion is often misunderstood. When a bank makes a loan, it does not create new money; rather, it makes an entry in the borrower’s account, which can be spent and deposited elsewhere. This cycle continues, but ultimately, the lending must be backed by some form of capital.

Fractional Reserve Banking

Bank lending is facilitated by something called fractional reserve banking. Under this system, banks are required to hold a percentage of their deposits as reserves. The rest can be lent out. For example, if a bank has $200 million in deposits and is required to keep 20% as reserves, it can lend out $160 million. The central bank may also require banks to maintain a certain liquidity reserve, which is typically around 10% of deposits in this case.

Types of Capital and Lending

Bank capital is a critical component of lending. Banks must maintain a certain level of common equity, known as the common equity cushion. This is to ensure that banks have capital to absorb potential losses. When a bank increases its lending, it must also replenish its capital.

Example: Bank Lending Mechanics

Consider a bank with $200 million in deposits, $15 million in bonds, and $20 million in shareholder equity. The bank keeps $10 million in vault cash plus deposits at the central bank. It then lends out $225 million. Here, the lending exceeds the deposit base, but it is not due to the money multiplier. Instead, the difference is that investors had capital to invest. The leverage multiplier in this case is 20:1, meaning for every $1 of their own capital, the bank can lend out $20.

The Role of Central Bank Reserves

The central bank creates only the $10 million that the bank keeps as a liquid reserve. However, depositors act as if they have $200 million in money. This is because the money supply is influenced by the bank's lending activities and the transactions initiated by customers. Any form of credit can operate similarly, sometimes with zero central-bank money for part of the time. However, the total lending is still limited by the bank's own capital and its ability to borrow.

Temporary State of Lending

Notably, when a bank funds a loan, it may appear as if the loan comes from the borrower’s deposit account. This is more accurately explained as a transaction between bank and customer. The borrower’s willingness to lend to the bank is a temporary state, as the borrower usually spends the money rather than simply keeping it in the bank. By the time the loan serves the borrower’s purpose, the bank must have found some other source for capital.

While the money multiplier theory can be misleading, it is essential to understand the principles of fractional reserve banking and the role of capital in lending. This knowledge is not only relevant to bankers but also to anyone interested in understanding the financial system.

References

For further reading, consult the works on monetary policy, banking operations, and financial regulation. Understanding these concepts can provide a deeper insight into how the banking system functions and the role of central banks in maintaining financial stability.