As a consumer, you may have deposited your hard-earned money into a bank, but have you ever wondered what banks do with your money? In essence, banks operate on a system of money multiplication and fractional reserve banking.
When you deposit money in a bank, it no longer belongs to you. Instead, it becomes the property of the bank, and you become a creditor. The bank then loans out this money to other people, and this is where the concept of money multiplication comes into play. Banks don’t lend out money on a 1 to 1 basis; they only need to hold around 10% of the money they lend out. This means that for every $100 deposited in a bank, $1000 can be generated from loans. This process multiplies the money supply by ten and is known as the money multiplier effect.
Fractional reserve banking is a banking system where banks only hold a fraction of the deposits they take in as reserves. The rest of the money is lent out to borrowers. In the UK, there is no longer a fractional reserve system, meaning that there is no limit to the amount of money that banks can lend out. This can be both good and bad. On the one hand, it allows banks to lend out more money, which can lead to economic growth. On the other hand, it can also lead to inflation and financial instability.
Interestingly, the majority of the money in circulation doesn’t physically exist. This is because the majority of money is held in digital form. Cash withdrawals in mass amounts would likely bring down any bank. In the event of a bank failure, the financial institution may protect a certain amount of your money. In the UK, for example, the maximum amount protected per person is £85,000 per ‘authorised institution’, while in the US, it’s $250,000.
It’s important to note that bank failures are more common than you might think. Since 2001, there have been 563 bank failures in the US and 8 in the UK. This highlights the importance of diversifying your investments and being aware of the risks associated with banking.
In conclusion, banks operate on a system of money multiplication and fractional reserve banking. When you deposit money in a bank, it becomes the property of the bank, and you become a creditor. Banks lend out money on a 10% reserve basis, which multiplies the money supply by ten. Additionally, most of the money in circulation is held in digital form, and bank failures are more common than you might think. It’s essential to be aware of the risks associated with banking and to diversify your investments.