Understanding How Banking System Works(2018 Edition)

We are still on banking system, types, functions, characters and today’s topic which is how banking system works. If you are studying banking and finance you should calmly read this post from the beginning to the end.

In case you’re didn’t see the post on what is banking system and types of it, you can go through the Post here.

There i went on to define banking system as the process by which financial institution like the commercial banks provide financial services to its customers. Financial services includes creation of bank account, making payments or deposit in the bank, collection of loans in the bank etc. All the services that a bank gives to you as a customer is what banking system is all about. You should also note that a central bank is a financial institution and so money creation by the central bank is also part of the banking system .

Understanding How Banking System Works

Banking system works

If you’re reading this, chances are you have a bank account, perhaps multiple accounts, to manage your ‘savings’ and investments (we’ll get to why savings is embraced by inverted commas later). Your salary, business, or other income is most likely paid into your bank account, and you spend it using a little plastic card. You may also have another plastic card, possibly several, that allow you to buy things even when your main account balance is zero.

You can also use your card to withdraw cash from little machines sprinkled all over town, in fact all over the world, a convenience that has become increasingly inconvenient as  more and more merchants accept card payments for even the smallest of transactions, thereby eliminating the need and associated risk of carrying around ‘bulky’ paper notes.

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This evolution from cash to cards over the last three decades has undoubtedly made transacting more convenient, but it’s also gifted the banking system full control over the currency supply. How so? Well, in simple terms it’s because cash is created by the government and electronic currency is created by banks. Few people really understand how the banking system works, so let’s break it down:

The first thing you need to understand is that when you deposit currency in a bank, you’re not putting it in a big safe, you’re lending it to the bank. When you make a loan to anyone, there is always a risk they won’t pay you back, and banks are no different (just ask anyone who had money in one of the 9,000 banks that failed during The Great Depression).

In the old days, banks made profits by collecting currency from depositors and lending it (at a higher rate) to borrowers, always keeping a little in reserve in case some of the depositors wanted their cash back. The reserve amount was dictated by the central bank (typically around 10%) so as long as no more than 10% of all depositors wanted their cash back at the same time, the bank would have enough reserves to cover withdrawals.

Let’s say a bank had $1,000,000 of deposits. It would reserve $100,000 and lend the rest out.  The $900,000 that was loaned out typically gets used to buy stuff, and the beneficiaries most likely deposit this money back into a bank.  Now the bank has $1,900,000 of deposits so it reserves an extra $90,000 and lends $810,000, which gets used to buy more stuff and the beneficiaries eventually deposit this cash back into the bank, so now the bank has $2,710,000. It reserves 10% and makes even more loans…. As this process repeats, the original $1,000,000 cash eventually creates up to $10,000,000 of deposits and $9,000,000 of loans. This system is known as fractional reserve banking.

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Now, since there’s only $1,000,000 of actual cash, all of which is sitting the banks as reserves, where does the cash to repay loans + interest come from? Clearly more cash must be printed and put into circulation… but that too gets multiplied by the same process, so eventually more cash needs to be printed again, and again, and again over time. Whether by accident or by design, fractional reserve banking is no different to a Ponzi scheme: just as a Ponzi scheme constantly requires new investors to pay returns to old investors, the Ponzi currency system constantly requires new cash to repay loans created by fractional reserve banking.

Most people think this is how banks work, but it’s not: fractional reserve banking has been subtly replaced by a far superior system (superior for the banks, that is), thanks to the almost complete elimination of cash. Recall that in a fractional reserve banking system, banks need cash deposits to make cash loans, so the bank can’t ‘multiply’ the cash until it’s re-deposited. Well, when money is electronic it’s re-deposited instantly, so banks can now creating currency out of thin air knowing it will be loaned back to them immediately.

Remembering that deposits are not stored by, but loaned to the bank, the increasingly cashless system we have today effective.

With this short and simple post, i know that you now understand how banking system works.

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