Banks not as piggy banks but as creators of money - a magical event happens

Ateneo Professor on Entrepreneurship

Rizal Philippines
July 23, 2019

How banks create money

I did not finish a business course while in college... I was naive and untutored in the world of business and finance.  Our first project after I quit working for someone was to establish a savings and loan association.

My first idea was that banking was a zero sum game, namely that if Bank A has deposit and a new bank, Bank B were to be established, the deposit that may be generated would be equal to or more than the deposit of A.  (A piggy bank concept)  Little did I understand that a bank does more than that -  it creates money.  Thus after one year,  the rural bank bank A had P2 million in deposits, and Bank B which we established had P5 million in new deposits.   Theoretically, our total deposit would be not more than the starting point of Bank 1. -  1 million deposits.

Why is this so?  Because the savings and deposit activity of the bank, creates (although not minting) money.   We thought that only the BSP can create money.  Yes banks create money.

When a bank lends, and assuming the community is a community of savers (there are no cash hoarders) the money lent is paid to  others in the community who again  deposits the amount of the bank.  And depending on the reserve requirement, the remaining free portion is relent and so on.  In a community where the reserve requirement is 20%, the multiplier effect is five times (inverse of the reserve requirement)  So the P1,000 deposit from loans becomes 5,000.   Thus when there is a bank run, banks run out of cash because the jump from P1,000 to P5,000 is a result of magic from fractional reserve system...

The Central Bank does even a greater magic when it prints money.  Who says there is a gold backing for our money. There is none..!!. Under the fiat or currency system, a gold reserve is not mandated.  The CB may buy from the money or credit it created gold bullions for security, US treasury notes or other valuable asset. but other than that, a central bank creates money from nothing.  All are purely
accounting entries

      1. To print money, CB does this accounting magic say P1 billion php

           Bills and coins                             P1,000,000,000.00

                             Bills and coins payable      P1,000,000,00.00  Just like that from nothing

    2.  From loans and discount operations;  CB lends to banks

          Loans and discount say                   P500,000,000.00

                            Deposit of banks                          P500,000,000

    Thus our BSP which has only P10B in equity may support total assets of trillions creating something out of nothing.

      Thus to grow a business, you have to create your own currency, IOUS (money is a liability of the Central Bank and the CB governor and the President are the signatories)

      1. At the business level, this could be gift certificates, (that can be negotiated and sold) as
          what SM did before

      2. Your own credit card  (say of Walmart, Shell etc)

If you do not know this magic, then you will be left behind.