Fractional Reserve BankingImagine a brand new bank is formed and starts with no money. Next customer A comes in and deposits $10,000 cash in a new savings account. Next the bank loans out $9,000 to customer B who takes his borrowed money out as cash.
This loan increases any measure of the money supply that includes both "demand deposit accounts at banks" and cash. That $9,000 is really counted twice. Since both customer A and customer B think they can spend this money, economists have decided it is reasonable to count it twice. Since there are 2 people that think they have this $9,000 it is inflationary.
So when a bank makes a loan from demand deposits they are increasing some measures of the money supply. In this sense people say, "banks make money".
This system of telling deposit customers they can take out their deposits on demand while at the same time loaning the money out for many years is called "fractional reserve banking". This is because only a fraction of the deposit money is actually kept on hand, say 10%. This type of banking has a terrible flaw. If a higher fraction of the customers demand their deposits back at the same time than the reserve ratio the bank can not give all of them their money. This is called a "bank run" and a "liquidity crisis".
The patch for this terrible flaw is to make a central bank that acts as a "lender of last resort" when a bank has a liquidity crisis and temporarily loans the bank some money. The central bank has a real ability to make new money, either electronic or having it printed. So the central bank can not run out of money.
A private bank can have a solvency crisis when the loans that it made are not paying. In this case the bank has a bigger problem that just a liquidity crisis. A temporary loan from the central bank will just delay the inevitable bankruptcy and not really fix the problem. The central bank is supposed to decide which banks just have a liquidity crisis and which have a solvency crisis and shut down the insolvent ones. It is sometimes not easy to decide if a bank is having a solvency crisis or a liquidity crisis.
If the central bank has the job of bailing out troubled banks then it opens itself up to being tricked by dishonest bankers. It is possible to make it look like they have a liquidity crisis, get a bunch of money from the central bank, and then run with the money. Of course the central bank tries not to get conned too often.
The current system with this "bank made money" can have deflation when lots of people are just paying down loans and not getting new loans. The overall money supply can go down. Then there is a patch for this. The central bank can print more money. But this has risks of inflation or even hyperinflation if the government gets out of control debt and deficit. So this deflation/inflation/hyperinflation trouble is another drawback of the current type of banking.
This type of bank can run into trouble if they make long term loans at current interest rates and then interest rates go up. Imagine they were paying depositors 2% and loaning money for 20 years at 5%. This is a healthy profit margin. But then imagine that short term interest rates move up to 6%. If they don't pay their customers this rate the customers can just take out their money and move someplace else. But if they pay depositors this much then they will lose money on their loans. There is a patch for this. They can have adjustable rate loans. But then if interest rates can change people who were credit worthy at the starting rate may not in fact be able to pay once rates have moved up. So adjustable rates loans have their own bad side-effects and were part of the recent crisis. So rising interest rates is yet another problem with this type of banking.
An alternative to fractional reserve banking is to always match the duration of deposits with the duration of the loans. To do this banks would sell 10 year bonds to raise money which would then be used to make 10 year loans. They would sell 20 year bonds to get money for 20 year loans. Since there are no "demand deposits" in this type of banking the banks are not "making money".
Since depositors can not just take out their money on demand, there is no danger that too high a fraction would all want their money at the same time that the bank would have a crisis. Avoiding the regular banking crisis of fractional reserve banking seems a big win.
It is also possible to loan out all of the money taken in and not just 90% of it. So this type of banking could in some sense be more efficient. If we are matching duration on deposits and loans then we will have real market pricing information on what interest rates should be at different durations. In the current system with most deposits short term and loans long term we are not letting the market tell us what long term interest rates should be.
I also think is more honest. If you tell all your depositors that they can take money out on demand, anytime they want, but really your bank is not operating in a way that it can do that then there is a bit of fraud going on. Even if the central bank can often patch up this problem it is still not clean. If I were in charge it would be illegal to do fractional reserve banking.
This type of bank still has to be careful to make good loans. But that is all. It does not have to get lucky about never getting a "bank run". It does not have to get lucky about interest rates not going up. It does not change the money supply, so does not contribute to the inflation and deflation problems. Avoiding the regular banking crisis of the current system can not be stressed enough.
Criticisms of my ViewThere are those who say that currently banks are not limited in their ability to loan by their reserves. This is certainly true for many banks. Since Bernanke came up with his new trick of paying interest on excess reserves, reserves are acting very different.
There are those that think banks make real money "out of thin air". To me these people don't seem to understand the simple example above where the bank making a $9,000 loan increases measures of the money supply. They think there is some other power to make money that banks have. So far these people have not been able to explain with sufficient clarity any other type of "bank making money" than my example above. If anyone can give a very simple example, like my $9,000 loan, where a bank has some different type of money making power, please do. If in your example you can not take out cash, then your bank is not like a real bank. Given that my example clearly works, it is not even clear why they think a bank needs any other power to make money. Isn't the ability to grow the money supply enough of a power?
I can not find a single example where "bank made money" is a real factor in hyperinflation. If private banks had some magical power to make money, and huge numbers of private banks, why is it that hyperinflation always involves central banks? Also, to get to run central bank you have to be far more qualified than to run a regular bank. Also, there are far fewer central banks. So if it was just a matter of making mistakes, we should expect private banks to do it far more often due to both larger numbers and lower qualifications. But it is always the central banks.
Another criticism of my view on banking is about statements I have made similar to "the $2 trillion in excess reserves flooding out into the real economy and cause inflation". Excess reserves is money that the bank holds above its reserve requirements. It could withdraw this money from the Fed as paper money if it wanted. The bank might loan the money out or maybe use it to for some other type of investment. I think that the reason the Fed has been able to make so much new money without causing inflation is that it has kept $2 trillion from entering the real economy by paying banks interest on excess reserves. I think that if the current $2 trillion in excess reserves comes into the real economy then inflation will kick up. People who are not worried about inflation have arguments about how this won't happen. But none of these arguments seem at all tight. Banks can loan out money. Banks can take out cash. Banks could invest in other things.
From the comments, the best example so far is a new bank is formed, it borrows $1 million at short term rates from the Fed and loans out $1 million long term. This would work but since there there is no "demand deposit account" the bank does not add anything to the money supply. The Fed probably just made the $1 million, so it probably added to the money supply, but the bank did not. Perhaps the Fed already had that money sitting around, either way, the private bank did not make money. Note this bank still has the interest rate risk problem. The Fed has the risk that this bank was formed by banksters who are just out to rip off the Fed. This example can work, but it is not a "private bank making money out of thin air" at all. Nothing close to a magic trick in what the bank is doing. It is getting money from the Fed and loaning it out. Nothing to see here, move along.
More from comments. Imagine it is after closing time and the bank makes two accounts for the same customer, who has put up his house as collateral. In one account there is a $100,000 loan and in another there is $100,000 deposit. No physical money has changed hands yet. The bank needs to use up $10,000 of its excess reserves but it has created a $100,000 demand deposit account. You could even imagine that the bank charged a $10,000 origination fee and used that for the reserve requirements. But at the start it sort of adds $100,000 to the money supply out of thin air. However, as the customer spends the money then the bank would have to get real money from the Fed or someplace else. Still, you can think of it as making the money and then getting the reserves later. This is the new best example of "making money out of thin air". :-)
More comments from Tom. Thanks so much Tom! He points out that there are a few really big banks with branches all over the place. So there is a chance that when the customer who got the loan spends money out of his checking account that the person he gives the check to actually uses the same bank. In this case the bank can do the transaction still without getting "real money".
Good Articles On "Banks Making Money"
James Tobin, Commercial Banks as Creators of “Money”