Conventionally banks are supposed to act as intermediaries between depositors and borrowers. It has been thought that banks use the money deposited to lend, but that could not be true as banks create the money they loan from their books. If the bank were to rely on deposits to support lending, it would have to secure more deposits relative to borrowing. In essence, this means that deposits create borrowing.
Lending does not depend on depositors’ money
Lending in banks is supplemented through the multiplier theory, which is consistent with fractional reserve banking. It’s important to note that in fractional reserve banking, the institution needs to hold only part of the depositor’s money in cash. The ability of a bank to lend is not dependent on its success in attracting new depositors but the monetary policy of the central bank on whether it can increase its reserve or not.
Instead of banks depending on deposits to lend, they, on the other hand, create deposits. When the bank lends someone to cash, it deposits the money in the borrower’s account, which is a matching deposit and thus creates new cash. In essence, the bank creates credit through deposits created in the process of lending. Therefore the bank doesn’t need to depend on the deposits customers make for them to lend.
Depositors help in balancing of books
However, deposits are important to banks because they help in balancing of books. Having more depositors is the easiest way of balancing books. When the bank lends money, it makes corresponding entries on the liabilities side and the asset side. The loan given will be an asset to the bank; it is offset simultaneously through the created deposit, which is the bank’s liability to the borrower.
Most importantly, banks can create money through loans, but the central bank’s reserve requirement restricts the ability to do so. The central bank may choose to increase or relax the requirement. Interestingly the requirement is not a binding constraint to the ability to lend and create money.