How banks create money out of thin Air? (2024)

Bank is a financial organization that accepts deposits and gives loan. It works as a financial intermediary. Banks play a major role in a country’s financial stability and economy. As a result, a bank is subject to numerous regulations. Banks can be classified as a commercial bank, a cooperative bank, Central bank, Regional Rural bank. RBI (Reserve Bank of India) is the Central Bank of India.

Banks generally earn money in 3 ways namely,

• Interest rate difference
• Investments
• Other banking facilities

Interest rate difference:

Generally, banks act as a depositor whenever the customer deposits his/her money into the bank, and then bank use this money to generate loans to their borrowers. In India banks have to set aside some fraction of the customer’s deposits for safety in form of cash or deposits with the central bank this is called asCash Reserve Ration (CRR).In India the current CRR rate is around 4.5%.

Apart from these banks also need to invest some number of total deposits in government bonds or in gold reserves or in some other form which is directed by the central bank, this is called asStatutory Liquidity Ratio (SLR).In India the SLR ratio is around 18%. So basically, Indian banks need to keep aside 22 to 23% of total deposits aside and the rest amount can be used by banks for giving out loans. In this whole process banks give around 4% rate of interest to depositors to deposit money with them and the bank charges higher rate of interest to borrowers depending on the type of loan and the difference in the interest rate is the profit earned by the banks.

Investments:

The deposits which are collected from the customers are either lent out for loan or invested by the banks in the capital market, debt market or in various other things like gold etc. In India if we see the balance sheet of government banks and private banks, we can clearly see that the major income for the government banks is from the investments because the government banks need to think for society so they provide loans at less rate of interest and lose on the profit from the interest rate difference.

Other banking facilities:

Bank also provide various facilities like credit cards, debit cards, bill of exchange facilities, provides passbook and many other services. Bank also acts as an agent where they pay our household expenses for example electricity bill etc. For this type of services banks charge some fees. Banks also earn through credit cards and debit cards by charging some annual fees.

Banks earn a major chunk of their income from interest rate difference and after that from investments. The other functions which are offered by banks account for a very small portion of income. Sometimes banks partner with some mutual funds/insurance company and become agents by selling their products and earn some amount of commission. In reality, banks do not “create” money, but merely act as intermediaries between buyers and sellers of assets. Banks do this by facilitating financial transactions of an asset through loans.