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🏦 How Banks Work

Your deposit is an IOU, not a box. Lending creates that money; the same mismatch that funds a thirty-year mortgage is what makes a run possible.

9
lessons
~35 min
to learn
🔢 Math
subject
Adults
level
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What you’ll learn

  1. Your Money Is Not In The BankRead a bank as a balance sheet and understand a deposit as the bank's IOU to you.Your money isn't stored at the bank — the cash became the bank's, and you hold a promise to be paid on demand. Liabilities are the bank's promises (mostly your deposits), assets are other people's promises to it (loans, bonds), and equity is the thin slice between. The Bank of England reported that, as of December 2013, bank deposits were 97% of UK broad money in circulation; currency was the remaining 3%.
  2. Where Money Actually Comes FromReplace the money-multiplier story with the central banks' own account: lending creates deposits.The Bank of England states that banks "do not act simply as intermediaries, lending out deposits that savers place with them, and nor do they 'multiply up' central bank money." Instead, "whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower's bank account." Both sides of the balance sheet grow together; repaying loans destroys the money again. The multiplier remains a teaching device the central banks themselves have disowned as a description of reality.
  3. So What Stops Them?Identify the real constraints on money creation — and see why reserves are not among them."Neither are reserves a binding constraint on lending, nor does the central bank fix the amount of reserves that are available." What binds instead: competition and profitability, credit risk, the fact that a newly created deposit usually walks to another bank and must be settled in reserves, prudential regulation, borrowers who destroy money by repaying debt — and above all monetary policy, which acts by setting the price of reserves rather than rationing their quantity.
  4. The Trick, And Why It Is Also The TrapUnderstand maturity transformation as both the product banks sell and the fragility they carry.Deposits are due now; loans are repaid over decades. Banks bridge that because while any one depositor might withdraw today, not all will — so long, useful things get funded by people who were never willing to lock money away. The pay for standing in the middle is the spread (net interest margin), and the price is two distinct exposures: credit risk (borrowers don't pay) and liquidity risk (they pay, but too slowly).
  5. Two Buffers Everyone ConfusesSeparate capital from liquidity — a size question and a timing question with different failure modes.Capital is not a pile of cash: it is the equity slice describing how assets were funded, and its job is to absorb losses before depositors do. Basel III minimums are CET1 ≥ 4.5% of risk-weighted assets, tier 1 ≥ 6%, total capital ≥ 8%, plus a 2.5% CET1 conservation buffer. Liquidity is a different question entirely — can you pay today? — and a fully solvent bank can die of the answer.
  6. The RunUnderstand a run as a self-fulfilling coordination failure, and see how insurance and a lender of last resort attack it.Because banks pay in arrival order, believing others might withdraw makes withdrawing rational — so a healthy bank can be destroyed by fire-selling assets to meet a panic it did nothing to earn. Diamond and Dybvig formalised this in 1983 (Nobel, 2022). Deposit insurance removes the advantage of being early — the FDIC's standard amount is $250,000 per depositor, per insured bank, per ownership category — and a lender of last resort lends against good collateral when markets stop, per Bagehot's 1873 rule.
  7. 2007: The Run That Started Before The QueueTrace how Northern Rock's funding model failed before any depositor queued.Between June 1998 and June 2007 Northern Rock's assets grew from £17.4bn to £113.5bn while retail funding fell from 60% to 23% of liabilities — the rest was short-term wholesale borrowing and securitisation. When those markets froze on 9 August 2007, the bank was finished; the BBC broke the news on 13 September and the Bank of England announced a facility on the 14th, after which the famous queues formed. As Shin wrote, the damage "had been done well before the run by its retail depositors."
  8. 2023: A Run At The Speed Of A PhoneSee how duration risk in 'safe' assets plus uninsured, concentrated depositors destroyed SVB in two days.SVB tripled in size from 2019–2021 and, per the Federal Reserve's review, invested largely uninsured deposits "primarily in securities with longer-term maturities" — mostly agency mortgage-backed securities and similar government paper, so almost no credit risk and enormous duration risk. Announcing a $21bn securities sale at a $1.8bn after-tax loss, and a $2.25bn capital raise, on 8 March 2023 told depositors exactly that; on 9 March SVB "lost over $40 billion in deposits" with "over $100 billion more" expected the next day — roughly 85% of the deposit base. About 94% of deposits were uninsured at year-end 2022.
  9. Why We Allow Any Of ThisJudge the trade society has made: keep the mismatch for what it produces, and patch the fragility it causes.Northern Rock held mortgages, SVB held Treasuries and agency mortgage bonds, and both died of the same thing — promises due now against assets that pay later. Banning the mismatch would end runs and also end the thirty-year mortgage, because the mismatch is what manufactures long lending. So we keep it and patch it: capital, liquidity rules, deposit insurance, a lender of last resort, and supervision to offset the moral hazard the others create.

Questions this course answers

In balance-sheet terms, what is your bank deposit?

Your asset is the bank's liability. The cash you deposited became the bank's property; what you hold is a promise to pay you on demand. The Bank of England describes deposits as "essentially IOUs from commercial banks to households and companies" — and, as of December 2013, they were 97% of UK broad money in circulation.

According to the Bank of England's 2014 account, which sequence is correct?

"Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower's bank account, thereby creating new money." The BoE explicitly rejects both alternatives: banks "do not act simply as intermediaries, lending out deposits that savers place with them, and nor do they 'multiply up' central bank money."

If lending creates money, what destroys it?

"Repaying bank loans destroys money" — the deposit is extinguished against the loan and both sides of the balance sheet shrink together. Money in a modern economy isn't a stock of stuff; it's a balance that grows with credit and shrinks with repayment. It's also one of the constraints: borrowers can undo new money by paying down debt.

Which of these is NOT a real constraint on how much money banks create?

The BoE is explicit: "the quantity of reserves already in the system does not constrain the creation of broad money through the act of lending," and reserves are not a binding constraint. Banks lend where lending is profitable and the demand for reserves follows; the central bank sets the price of reserves, not their quantity.

An individual bank makes a mortgage and creates the deposit. The borrower buys a house from someone who banks elsewhere. What happens to the lending bank?

This is why banks scramble for funding despite creating deposits by lending. The deposit walks to another bank, settlement happens in reserves, and — in the BoE's words — "if a given bank financed all of its new loans in this way, it would soon run out of reserves." The system creates deposits; each bank fights to keep its share.

Why is maturity transformation valuable rather than merely reckless?

Nobody can have a thirty-year loan funded by money returnable on demand — unless you have enough depositors that "any one might withdraw" and "all withdraw at once" come apart. Banks manufacture that reconciliation, and houses and businesses get funded because of it. The fragility is the same fact from the other side.

Grounded in trusted sources

  • Michael McLeay, Amar Radia and Ryland Thomas, "Money creation in the modern economy," Bank of England Quarterly Bulletin 2014 Q1 — https://www.bankofengland.co.uk/quarterly-bulletin/2014/q1/money-creation-in-the-modern-economy
  • Bank for International Settlements, FSI Executive Summary, "Definition of capital in Basel III" — https://www.bis.org/fsi/fsisummaries/defcap_b3.pdf
  • Basel Committee on Banking Supervision, "Basel III: A global regulatory framework for more resilient banks and banking systems" — https://www.bis.org/publ/bcbs189.pdf
  • Hyun Song Shin, "Reflections on Northern Rock: The Bank Run that Heralded the Global Financial Crisis," Journal of Economic Perspectives 23(1), 2009 — https://www.bis.org/publ/shin_2009.pdf
  • Board of Governors of the Federal Reserve System, "Review of the Federal Reserve's Supervision and Regulation of Silicon Valley Bank" (April 2023), Executive Summary — https://www.federalreserve.gov/publications/2023-April-SVB-Executive-Summary.htm
  • FDIC, "Understanding Deposit Insurance" — https://www.fdic.gov/resources/deposit-insurance/understanding-deposit-insurance
  • Douglas W. Diamond and Philip H. Dybvig, "Bank Runs, Deposit Insurance, and Liquidity," Journal of Political Economy 91(3), 1983
  • Walter Bagehot, Lombard Street: A Description of the Money Market (1873)

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