In recent weeks, we have been witnessing traditional banks going bankrupt or experiencing a lot of trouble. This is not an isolated incident, but a widespread problem in the banking sector. It's not out of the blue either - for over a year now, the data has been showing us that this will be the outcome. Interest rate hikes, rumors about troubles in Credit Suisse, rising inflation, signs of a recession, and the worst of all, every month, a new all-time high in consumer debt. The question on everyone's mind is, "how can debt be that high?"
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We used to think that banks receive our money in the form of deposits and then use those deposits to provide loans and get interest, which generates revenue to keep the lights on. Banks help the economy generate more output, more jobs, and better the lives of everyone, some would say they are doing social work. The depositors who provide the banks with the means to give those loans are also getting a piece of the profits in the form of interest based on the amount of money they deposited. There is also a formula on how much money banks can have, depending on their deposits. That formula is called the reserve ratio. Basically, the reserve ratio is the money each bank is obliged by law to keep in cash and not loan or invest. That percentage is decided by the Fed, and when the economy is doing well, or they want to give a boost to the economy, they lower it, and when they want to tighten the economy, they increase it. But how does that work? Let us assume that we have the Steemychicken1 bank, and we have $100,000 worth of deposits. Now, the percentage my bank is obliged to keep is 10%, making it $10,000, so I can effectively loan the remaining $90,000 to businesses or retail customers. Suppose Steemychicken2 comes and asks for a loan of $90,000. In that case, I give the loan, and then Steemychicken2 deposits that $90,000 to another bank. That bank has to keep $9,000, which is 10%, and can loan the rest, $81,000, and so on. Keep in mind that while banks loan the money, each depositor has their initial amount they deposited, so new money has been created. The process can theoretically stop when the initial $100,000 has produced $1,000,000 in loans.
However, this is not how banks loan money in any major economy. Loans, like everything else in the capitalist system, work on a supply and demand basis. When the demand is rising, then the supply is rising as well, but where does the money come from? Well, the banks create that money. Steemychicken1 goes into a bank and asks for a loan for a new business he wants to open. The bank researches his financials, etc., and you would think they would also look into their reserves, but no - they type the amount they want to loan into the computer, and that reserve is now created. After that, they loan that amount to Steemychicken1, and that's how banks create new money out of thin air. So a bank can have $1,000,000 worth of real deposits and could have given with that method $20,000,000 worth of loans, or even more.
Of course, this process is a lot more complex, and I believe that central banks have many ways to keep banks in check and not over-loan. But I also believe that when everything goes well, they won't be checking that much because high bonuses and revenues are in the middle. And it is unlikely that the high paid bankers would be held solely responsible for the consequences. Instead, it would likely fall on taxpayers and the government to bear the burden of any resulting financial losses.
Now i will provide some links for anyone who wants to take a deeper dive in the whole process.
