I am tired of the amount of crap posted here when it comes to banking systems. So I will post some explanations as best I can, and I hope to God I will not make any mistakes in the following;
I'll work through an example
For the US Fractional Reserve Banking System since that is what most people seem to be talking about, and that is where a lot of fiat money is created. I will be using a classic reserve ratio of 1:9 - although it's actually 1:10 or 10% in the US, however in reality fractional reserve requirement are irrelevant in the modern world, and do not even apply on all bank deposits - which is why most of the world has done away with them. However in the US it does still hold a lot of relevance for banks' convenience - but do not take this to mean they are in any way constrained by it.
Now, assuming a ratio of 1:9
for every individual X dollars deposited, the banking system can lend:
(X * 0.9 ) + (X * 0.9) * 0.9 + ((X * 0.9) * 0.9) * 0.9 + ..... to infinity
In other words, this is an infinite series of X*0.9^n. Luckily this is geometric series, whereby we can find it's limit.
The limit can be calculated by L = (X / (1 - 0.9) ) - X. Note the - X is to take out the original deposit.
Long story short, for every $1 of customer money deposited into the banking system, it will create up to $8 out of nowhere, resulting in a total of $9 within the banking system.
However that's only customer deposits - and you would be right to wonder where the hell the $1 comes from if it was not already in the banking system to begin with.
Banks can (and do as part of FRB) deposit money at the central bank. This money makes up some part of their fractional reserve. This money, they can draw upon
in a different way - borrowing in a 1:9 ratio, that being if a bank has $1000 deposited at a central bank, it can then borrow $9000 from the central bank - at the central's bank special interest rate. This is not money that neither the retail bank has nor the central bank has at the time the retail bank made a request for it - this is money which the central bank now prints out of thin air and lends to the retail bank, which then re-lends it to the customer.
At that point, the money created out of thin air by the central bank enters the banking system, and can then be redeposited and relent in a 9:1 ratio, so that $9000 will create up to an additional $81,000.
The original $9000 borrowed from the central bank must be eventually repaid with interest, leaving the vast majority of the additional amount of money created within the banking system - up to $81,000 in it's circulation.
Thus, the $9000 borrowed from the central bank is
destroyed just as it was created, the interest paid to the central bank on that loan is
paid out in part to the US Federal Treasury and in part to the private shareholders of the Fed, and the up to $81,000
stays within the banking system, being created out of nothing.
Hopefully this example conveys both the
complexity and the
end result of how FRB works. I will also say as a disclaimer lest I be misunderstood, not all of the money which the bank sets aside as it's fractional reserve is leveraged in this way, and it is very short-term debt which must be paid back quickly - in reality it is re-payed and re-borrowed very quickly as new money is created from it continuously.
That amount of money - up to $81,000 is what increases the monetary supply and what creates inflation.
Again, I cannot fathom how stupid it is to suggest that banks only lend out a portion of deposits. If this was true, there would be no money left in the world a long time ago. How do you suppose M1 grows?
Not to mention the money supply in every country grows simultaneously, no one country is lending to another - money is created constantly in very large amounts.
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As a further added note, according to the Fed's reports, as of the 9th of May, the top 25 US commercial banks have a total of $4,069.7Bn - in other words, over $4Tr borrowed from the Fed. Foreign commercial banks have borrowed around $1Tr, although I am personally unfamiliar with what sort of collateral if any a US bank would need to provide the Fed to borrow money from it. The point is however, as of 9th of May, the Fed has over $4Tr that it created out of nothing and lent to the retail banks. Every minute that money (which will eventually be destroyed) stays in the banking system, it creates new money (which will stay in the banking system).
But the most important thing is that
Unlike the US, Australia does not use the Fractional Reserve Banking System, Australia has no fractional reserve requirements, the amount of loan money created in Australia bares no relation to any reserve requirements (because they don't exist!), The RBA does not print money and lend it to Australian banks as happens in the US as well as other countries (not always necessarily under the FRB system either).
Does that mean that Australian banks get loan money from deposits, or that they are constrained in any particular way by the amount of deposits they have when it comes to creating new loans?
NO, there is no direct relation between the amount of deposits an Australian bank has, and how much money it can lend out - and this applies collectively to the entire Australian banking system.
In fact, if you look at the balance sheet of any Australian bank, although I have not checked each one personally, I can guarantee that not a single one of them will have anywhere near enough deposits to cover their loans on a 1:1 basis as some posters would claim.
Just for the record, I think if they did have to make all loans from deposits, that would be great - but that's not how it works.
No, lending money has little to do with deposits. Loans must be funded yes, and deposits are one way of funding loans yes -
however fundamentally speaking, loans can be funded entirely and indefinitely through borrowing.
In the US, in simple terms, all the money banks need which isn't funded by deposits they can get directly from the Fed.
In Australia, banks do not have anywhere near enough deposits to fuel our housing bubble, and as the RBA does not lend them money, they are forced to borrow it from foreign banks, which can borrow money from their central banks whom in turn create it out of nothing.
Neither US nor Australian banks are limited by deposits or anything else regarding how much money they can create as loans.
However both US and Australian banks are limited in terms of how much money they can loan out by capital requirements - which prevent the banks from becoming insolvent by having enough capital to cover what is considered to be a reasonable amount of losses in it's lending portfolio.
Understand that the above are two separate concepts.
By this time you might wonder what that means for Australians and their banks.
Broadly speaking, it means we have borrowed from other countries the money to fund our speculative housing bubble, and must in turn pay that money back with interest. This money and interest are created through the hard work of Australians, through the sweat of our miners, the inventions of our scientists, the ingenuity of our manufacturers and the skills of all other professionals who provide various services. Much of this wealth that we create every year is taken away from us to fund our massive current account deficit instead of staying in Australia to be spend on things like infrastructure, research and development and entrepreneurship.
So there you have it, the money created out of nothing by foreign central banks - that is what funds (about 40% of) our housing bubble, creates a lot of our inflation and robs us of our wealth.
Lastly, this is only some of the many problems with central banking. While it would clearly be more advantageous for Australia if the RBA printed our own money and lent it to our banks at it's own cash rate so that they would not need to borrow from overseas, and taxpayers would not have to be made liable for their borrowings in times of significant crisis - believe me that will not address other problems with central banking and create different problems which we don't have to face due to the fact that RBA doesn't lend to our banks (borrowing infinite money and gambling on derivatives for instance).
