Toro
Diamond Member
This is incorrect. A bank does not take $1000 in deposits and creates $9000 in loans. It takes $1000 in equity and makes $9000 in loans.
A bank's balance sheet will look something like this:
Assets
Loans $10,000
Total Assets $10,000
Liabilities
Deposits $9000
Shareholders Equity
Common Stock $1000
Total Liabilities and Shareholders' Equity $10,000
A bank makes its profits based on the spread of its return on assets less the cost of liabilities. Its profits like this.
Return on loans 10% x $10,000 = $1,000
Cost of deposits 2% x $9000 = $180
Profits to shareholders $820.
The amount of loans a bank can make is dependent on the amount of liabilities and shareholders' equity it has. In our above example, if the bank can only raise $4000 in deposits, then it can only make $5000 in loans. This isn't money that is being created out of thin air. This is acting as an intermediary between savers and borrowers.
Where banks make money out of thin air is in the amount of loans it can make based on the amount of equity it has. If the reserve ratio in our example is 10% (the amount of equity to total assets, or $1000 in equity divided by $10,000 in assets), and the bank retains all its earnings, in the following year, the bank would have $1820 in equity, and could increase the number of loans by $8200 only if the bank can find deposits (or some other source of funding). If the bank cannot find deposits or other sources of funding, in our example, it could not lend out an extra $8200.
