The Modern Banking System: How Banks Use Deposits and Generate Profits
Banks play a critical role in the global economy. But how do they use the money they receive from deposits, and how is this system different from what was once widely believed? This article explores the complexities of modern banking and the modern role of commercial banks in generating profits.
From Traditional to Modern Banking
Several decades ago, deposits in banks were listed on the left side of a balance sheet as assets. This iconic system played a vital role as banks acted as intermediaries between savings and investments. Depositors' money was loaned out for interest, creating a cycle of economic growth and prosperity.
However, this traditional view of banking has evolved significantly. Today, across much of the developed world, including New Zealand and Canada, the banking system operates differently. Deposits are now listed on the right side of a balance sheet, as liabilities or money that the bank owes to its customers.
The Role of Modern Banking
While bank profits in the past were often derived from the interest earned on loans, today, banks primarily generate profits through the creation of new credit and charge interest on loans. Modern banking involves a process where loans are extended, which creates new bank reserves, and these reserves enable banks to issue even more loans. This cycle of creating credit, without first having the reserves, is a core aspect of modern banking.
Money Creation and Inflation Targeting
The complex mechanisms of money creation and inflation targeting further complicate the traditional understanding of banking. The Bank of England published an article in 2014 that explicitly stated, "commercial banks do not lend out deposits." Instead, loans create new money, and banks are solvent through this dynamic process.
Other institutions, such as the German Bundesbank, have also acknowledged that commercial banks, not the central bank, create credit money. Despite this, many financial educators and commentators continue to promote the traditional fractional reserve banking model, which may lead to misconceptions and confusion among the general public.
The Discrepancy in Public Understanding
There is a significant discrepancy between the textbook explanations of modern banking and the actual practices within commercial banks. The majority of people do not typically interact with the complex mechanisms that create credit. Instead, they only experience the limits of their credit capacity, which remains influenced by traditional monetary policies and economic conditions.
Profit Generation and Customer Attraction
The primary focus of commercial banks is to attract customers who can take on large loans and have the means to repay them. Banks see these customers as more attractive because loans, rather than deposits, generate the majority of their profits. This explains why banks increasingly treat individuals and companies with substantial loans as better customers than those with only savings accounts.
Consider the process of obtaining a mortgage: a customer approaches a bank for a home loan, and the bank agrees based on the customer's income. In the conventional view, the bank lists the mortgage as a liability, but the immediate benefit comes from the loan's ability to create new money through the banking system.
However, in practice, this process is more complex. Determining which bank the seller uses is not typically part of the due diligence for mortgages. Banks benefit from creating new money through loans rather than waiting for modest interest payments from deposits.
Conclusion
The modern banking system is significantly different from the traditional model, with a focus on creating credit and generating profits through loans. Understanding these changes can help clarify the role banks play in the global economy and how they generate their income.
To learn more about the modern banking system, explore the resources and articles available, including the complexities of money creation and the role of central banks. By demystifying these processes, we can gain a clearer understanding of how the financial world operates and why certain business practices are prevalent.