Where Do Banks Get Their Money?

There are two primary sources through which banks secure their funds: customer deposits and the wholesale banking markets. Customer deposits are a foundational source, while the wholesale markets have become increasingly significant in modern banking.

Customer Deposits

Firstly, banks receive funds primarily from customers through various mechanisms. Customers either deposit their surplus money in demand or term deposits, or they leave surplus money in their current accounts. While regulated reserves are required by law, the remaining funds can be loaned out to customers in need of credit. This was the original primary source of money for banks and remains a crucial component today.

Wholesale Banking Markets

As banking evolved and became more sophisticated, a secondary but very important source of funding emerged: the wholesale banking market. Through these markets, banks can borrow large quantities of money at low rates and then lend it to customers. Wholesale markets consist of surplus funds from banks that cannot find suitable customers to lend to, as well as institutions such as pension funds that are seeking to invest their own money.

The secondary market has grown to become the largest source of funding for banks, allowing them to maintain liquidity and provide a wide range of credit options to clients.

Initial Capital

In the beginning, banks can also use some of their initial capital as a funding source. The initial capital typically comes from direct investment by shareholders, but this is not a primary source of funding over the long term.

Deposits as a Source of Funds for Lending

A significant portion of the funds that banks use for lending comes from customer deposits. Banks operate on the principle of accepting deposits for the purpose of lending or investment. When customers deposit money, the bank pays a lower interest rate on these deposits and lends at a higher interest rate, resulting in a profit for the bank.

The Mystery of Money Creation

Interestingly, banks can create money through the process of loan origination. This is a fundamental aspect of banking that can seem somewhat magical to the uninitiated. Let's break it down:

Customer Loan Request: A customer requests a loan from the bank. Bank Approval: The bank approves the loan. Accounting Entry: The bank credits the borrower's account with the loan amount, and debits its own account by the same amount in the accounting records.

This means that the money did not physically exist before the transaction, it was merely created through an accounting entry. This process is formally recognized by the Bank of England and is a core part of the way banks operate in a modern economy.

It is worth noting that while this process can be seemingly miraculous, it is a legal and accepted practice in the banking industry. However, it can also lead to criticisms and concerns about bank lending and the stability of the financial system.

Conclusion

In summary, banks rely on a combination of customer deposits, wholesale funding markets, and initial capital to secure the funds necessary for lending and investment. The process of money creation through loan origination is a fundamental aspect of how banks operate, allowing them to provide financial services and generate profits.