‘Do you think I am a bank?’ My mom would shout whenever I ask money. To her, bank is a store of money.
She thinks banks print new money whenever they need. So, as a young boy my ambition was becoming a Bank Manager.
But is my mother right? Are our banks storehouses of money? Do they really print new money whenever they need?
Who Prints New Bhutan currency Ngultrum?
First of all when we talk about new money in the country, there are two things to consider:
- Creation of the new money
- Printing of the new money.
The central bank of a country actually prints new money of that country. In Bhutan Royal Monetary Authority prints our money Ngultrum.
The central bank is the bank of the government. But it’s also the boss of all other banks operating within the country.
Royal Monetary Authority of Bhutan
Though the central bank prints physical money, most of the new money are created by banks.
Money creation happens when we deposit our money and banks loan out to others.
The normal operation of banks create new money through the system of fractional-reserve banking.
In any country, less than 3% of the total money is printed. The other 97% is just digital figures inside computers of the central banks and all the commercial banks.
When the amount of physical money held by all the banks put together is less than the amount printed, they will encourage people to deposit.
It’s expensive to print new money.
In principle, the physical notes in circulation must be equal to the amount printed and issued by the central bank.
In case latter is more than former, the difference will be an ‘unaccounted money’.
It’s what we call Black Money.
Black money is not good. If it grows out of safe limit, they will retrace and burn the existing notes to compel black money holders to deposit with the banks.
USD notes have expiry dates. China is planning to do the same. India did demonetization campaign in 2016. All of these are just to keep the black money very low.
How Commercial Banks make Money?
Banks cannot print new money. However, their fractional-reserve banking system creates new money – a lot actually.
Therefore, the loan interest is always higher than the interest they give to depositors.
Assume Dorji deposited Nu.100,000 @ 4% per annum.
The moment he deposits Nu.100,000, the bank will give away as loans at higher interest rate say 9% to someone.
The bank made 5% profit on Nu.100,000 whereas the owner of the money i.e Dorji got only 4%.
But that is not it. Banks make the same profit as many as 10 times out of Dorji’s money alone through the fractional-reserve banking system.
It’s the main source of revenues for the banks.
Fractional-reserve banking is also the largest creator of new money in the country.
How much of deposits Banks can loan out
Banks accept deposits from one customer and loan to another. But they cannot give 100% of deposit amount as a loan.
They must keep portion of it as cash reserve or statutory liquidity reserve. The two ratios determine what % of deposit can be given as loans:
- Cash Reserve Ratio (CRR)
- Statutory Liquidity Ratio (SLR)
Cash Reserve is the portion of cash deposit the banks have to keep with the central bank.
If our CRR is 10%, then banks must keep Nu.10 as a reserve from every Nu.100 deposit. They can lend only Nu.90 as a loan.
But statutory reserve is the portion of deposit the banks have to maintain with themselves to ensure solvency of the banks.
Unlike in CRR, SLR can be in the form of any liquid assets (cash, stocks, CODs, precious metals, bonds, etc.) Banks also earn interest on this reserve.
CRR and SLR might look identical for you. However, they’re different in their objectives, forms, uses, returns etc.
How Fractional-reserve Banking works
If you know how pyramid schemes work, you’ll know how the fractional reserve banking system works.
In earlier example, the moment Dorji deposits his Nu.100,000 the bank will keep 10% as cash reserve and loan out Nu.90,000.
The Nu.90,000 will soon be back to the bank as a deposit. Bank will keep 10% and loan out Nu.81,000.
This process will continue until the written down amount of Dorji’s initial money becomes zero.
In above illustration Nu.309,510 new money has been created – the loans given to Karma, Tenzin, Jamtsho and Sangay.
Nu.1 million will be created by the end of the process as the formula for that is deposit/CRR. So,100,000/0.10 = Nu.1,000,0000!
We have assumed only one bank in the example. But in reality no country has just one commercial bank.
Can you imagine how much new money will be created? It will be in tens of trillions.
But are they real money? Of course no. They are just digital figures inside the servers of the central bank and other commercial banks.
Moreover, just think how much interest income the bank will make from Dorji’s money alone when they give him only Nu.4,000.
Trust is important to work this system
In the fractional-reserve banking system, customers must trust the bank as much as the bank must to its customers.
Otherwise the system will collapse.
People like Karma, Tenzin, Jamtsho, and Sangay must pay their loans on time with interest.
Dorji, Dema, Zam, and Choden all together shouldn’t withdraw all their individual’s deposits at the same time before maturity.
Banks match maturity dates with the due dates of the loans. Otherwise, depositors won’t have money when they withdraw their deposits.
Dorji’s deposit matures on 31st March. However, he wants to withdraw it on 9th March.
But the bank doesn’t have any money on the 9th March. No loans were paid to match Dorji’s Nu.100,000 deposit withdrawal.
Dorji will then lose trust on the bank. People who also have their deposits will rush to the bank to withdraw their money.
But the bank doesn’t have the money.
This will cause bank-run which will then collapse the illusionary money creating system and earlier depositors losing their savings.
We observed one of the bank-runs in 2007 which then led to the global financial crisis 2007-2008. It’s now happening in China.
In above example, Dorji’s Nu.100,000 turned a million out of thin air. But there is no actual money. To prove it, all depositors all together at the same time won’t be able to withdraw all their money at once.
The bank will have money only when someone pays back the loans. This case, no one did.
In any given time, even if 5% of total deposit money is withdrawn at once this banking system will collapse.
Therefore, you won’t disagree that banking is the biggest ponzi scheme of the human civilization.
How Central Bank controls the Money Supply
The main role of the central bank is to control inflation by controlling the supply of money in the country.
This means when inflation is high, RMA will reduce the supply of money. It’s based on the law of demand and supply.
How does RMA control the supply of money in Bhutan?
The most important tools are the two reserve ratios (CRR and SLR) and the bank rates. When ratios are high, money supply will be less.
Dorji’s Nu.100,000 will be able to create only Nu.500,000 new money if CRR is increased to 15%.
In above graph, money supply is M2 when CRR/SLR is S1. However, it’s reduced to M1 when CRR/SLR is increased to S2.
The initial money for the banks is actually loans given by RMA. Bank rate is the interest RMA charges.
When bank rates are high, banks will also increase loan interest. People will take less loans and creation of new money will be reduced.
This means when inflation is high, we can say RMA must have reduced these ratios or bank rates or both to increase money supply.
If adjusting them doesn’t help in controlling the inflation, government will issue bonds to take back excess money from people’s hands.
The value of money you and I have is also determined by someone. Gold standard has been removed since 1972.
The central banks across the world can now create or burn money easily as money is now jus papers backed by nothing.
It works due to people’s trust to their banks and faith to this grand ponzi scheme of modern banking system.
This is the main reason why decentralized cryptocurrencies like Bitcoins came up into existence. Government cannot manipulate supplies and values of them.
It’s very important to know such things. Otherwise, you’ll not only think banks print money but might also make mistakes while investing your money.
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