Inter-bank loans and the banking system

Money may be created by transferring it from a loan account to a savings account, which also creates a debt in the loan account.


As long as the loan account and the savings account are in the same bank, no money enters or leaves the bank in this process, so the total amount of money in the bank doesn't change. Because the total amount of money in the bank doesn't change, creating money and debt this way doesn't cause a problem because the bank doesn't need to get any money from anywhere for it to happen.


What if the money is being transferred to an account at a different bank? You may expect that the bank will need to get some money from somewhere to do this.


Many transfers won't be between accounts that are held at the same bank. However, a bank handles many transactions and what it gives out in one transaction it is likely to take in, in another. As long as the overall value of all withdrawals from accounts is equal to the overall value of all deposits into accounts the necessary balance is kept. The process looks like this:



If the value of all withdrawals does exceed the value of all deposits, then the bank will have to bring in some money; it does this by borrowing money from another bank (a bank for which the value of all deposits exceeded the value of all withdrawals.) This loan (called an inter-bank loan) acts as though one more person borrowed money at another bank and spent it with someone who has a savings account at the bank, making up the shortfall to create the necessary balance.  The process looks like this:



As long as all transactions between banks are direct transfers

(EFTPOS, credit cards, cheques, and direct deposits), then the banking system as a whole will necessarily balance withdrawals and deposits, because every withdrawal from one bank must be transferred, as a deposit of the same value, to another bank somewhere else in the banking system.  Inter-bank loans means that all banks are effectively one bank: the banking system.


However, money withdrawn as true cash can leave the banking system, as it can end up in people's wallets or purses, cash registers or safes, or in a drawer at home. If there are more true cash withdrawals than true cash deposits, then the banking system as a whole will fall short. Banks keep a reserve of cash for the purpose of balancing if this occurs.


This page is linked from:

spending money created by borrowing

Transferring money between banks


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