In classical economic theory banks have two functions. They facilitate economic transactions by “clearing” or settling through checking accounts, and they make loans to individuals or businesses. In mainstream economic theory when banks make loans they are lending money deposited by customers in their accounts. The idea is that depositors do not need all the money immediately, especially when it is deposited in “savings” accounts, so the bank can put some portion of it to work in loans. 

This theory seems to imply that the banks deposits are all currency that is held in its vaults and that the loans are made by doling out some portion of that currency. Needless to say most banks deposits these days are bookkeeping entries rather than actual currency, and loans are made simply by crediting an account via another bookkeeping entry. In fact most of the “money” in circulation was “created” by similar bookkeeping entries somewhere in the financial system, and, once loans are repaid, the money that was created by them evaporates. Most people will probably balk at this idea initially, because they think of money as a physical thing – a limited resource that circulates through the economy and is not just some bookkeeping entry that can be erased or evaporate like fairy dust. 

The idea that a bank’s ability to make loans is limited by the amount of money it has on deposit is the reason that banks can “fail” when there is a “run” on the bank and too many depositors demand their money back.  Traditionally banks were required to limit their loans to a certain percentage of their deposits, but over the years the amount of reserves required has decreased from 25% to 0%.[see Regulation]  Since the reforms triggered by the Depression, bank deposits have been insured in order to prevent bank failures.  They are currently insured up to $250,000, but that did not prevent the Silicon Valley Bank from failing in 2023 even though it had over $170 billion in deposits.

^BackToTop