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| Idea - I am not sure where to start. I try to make my banking posts as simple as possible so everyone can understand them without going over their head.
First of all, a majority of the banks in the US are not even members of the Federal Reserve Banks, so there is no entry on their books that includes and entry with the Federal Reserve when they make loans (period). That includes our bank.
Secondly, lets suppose you are a bank. Let's assume you are rich and have a lot of your own money to begin with. Let's say you have a Million Dollars that you keep locked up in a safe vault that no one penetrate and you and your vault are the envy of the entire town. For this and other reasons a lot of people just trust you and decide that they want you to hold their money for them b/c they know you will be a good steward of it, will protect it from theft, and they can just rely on you to give them their money back if they ever need it. Nice guy that you are, you agree to hold their money, all goes well, you safe keep their money, its sits there doing nothing, and people do from time to time ask and receive a portion of their money back. More and more people in town give you their money for safekeeping as your reputation grows and you end up safekeeping not only your original $1M, but your friends and family have deposited with you $2 Million of their money as well. So, your well kept safe vault now has $3M in it.
More time goes by and the money just sits there, but one day you, Idea, come up with an idea. You are a nice guy and everything and have been safekeeping everybody's money for them for free, but you happen to notice no matter how many times people want their money back, there is another person who wants to deposit an equal amount of money with you, so at the end of the day you still have that same $3M dollars in your vault. You also happen to be the only gig in town by the way, so you have now figured out that all the people in town have $2M and you still have retained your $1M for a total of $3M. So, you have been trying figure out a way to profit from your safekeeping venture and you say to yourself, what if I lend out a portion of the $3 Million dollars that is just sitting in the vault each night doing nothing to someone else who could use a loan? I could charge that borrower interest that could make my original $1M grow and my depositors will not care b/c they will not even notice that I lent part of their money to someone else. The original depositors will just continue to take same measly sums out and someone else will just redeposit that money back into my vault. All they want is immediate access to just a portion of their money. That is it.
So, you do just that. You now lend $1 Million of the depositor's original $2 Million to another person. Remember for the sake of simplicity, you are the only gig in town. So, now you only have $2 Million in your vault in cash of which $1 Million is yours and $1 Million belongs to the depositors. But, now you also have a paper loan for $1 Million in place of the $1M that you loaned out and that borrower has the other Million in cash. To your great pleasure, the very next day, a new depositor from your town brings in $1M to you, telling you of his good fortune in that he able sell some of his land to your borrower for at a great price of $1M and he now wants you to safe keep that new Million dollars in your vault.
What just happened to your bank and the money supply of the town? Well, you now have your original money of $1 Million, you have the depositors who have their original claim of $2 Million, but you also have this new $1 Million from the seller of land. Happy day. You have all the original $3 Million back in your vault, Except $1 Million of that money is now leveraged to your borrower who is paying you interest on $1 Million, while the depositors have $3 Million in claims on you in addition to $1 Million that is yours. So, you just grew they money supply by $1 Million without the aid of a Federal Reserve and you are now a $4 Million Bank
That is what happens when loans are created. Even if that money is not re-deposited into your bank, it is now in the banking system of the nation. It is as simple as that. That is what John is referring to when he talks about leverage. You can see the higher you leverage your original $1 Million Dollars in loans, the greater the money supply becomes. You start with an unleveraged $1 Million, but if you keep repeating the above process, your $1 Million can create another $9 Million in deposits and via the issuance of $10 Million in loans. Your equity position/reserve would then be at 10% which happens to be the average of banks in Iowa.
Again, if banks are not lending and are shrinking their balance sheets, that does necessarily imply that the money supply is also shrinking.
I am defining money supply as the depositor's total money in banks. I realize there are all kinds classifications of M!, M2, etc. forms of money, but I will let others go into that as it will just confuse most hear who just want to understand how our fractional form of banking works.
Edited by Iowegian 12/13/2014 12:57
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Banking, one more time....
