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Finance , Investing

From Where Do Banks Borrow Money?

September 6, 2016

Q: From where do banks borrow money cheaply, when interest rates they offer to their depositors are at record lows?

First know this: Banks are in the business of making money. They are not charities, they are not interested in being giving, and they care more about themselves than their customers.

With that said… the answer is in the question.

Banks borrow money cheaply from their depositors.

Anyone who has a bank account can attest to the ridiculously low interest rates that the bank pays. The rate of inflation is much higher than a bank account’s interest rate.

In fact, by leaving your money in a bank account, you are actually losing value through inflation.

When a bank receives money from a depositor, the bank then loans out a portion of that money. This is called fractional lending. It’s how banks make money – they loan out a portion of what has been deposited.

Now, many banks have minimum amounts of liquidity. That means that they only loan out a certain portion of their total deposits.

For example, let’s say a bank has 50% liquidity; that means that they keep at least 50% of their deposited money ready for customers to withdraw at any time.

But, when you leave that much money just sitting there, the bank isn’t making any significant returns.

So… what do most banks do? They loan out most of the money that is deposited by their customers.

In the US, some banks loans out up to 98%. That means for every $100 deposited, the bank then turns around and lends out $98 to various investments.

If you think about that for a second, it is actually terrifying.

Let’s pretend that 100 different people open up a bank account at the same bank. They all make similar deposits into their own savings account.

If we use the 98% example, that means that if all 100 people went back to the bank to get all their money out, ONLY 2 PEOPLE WOULD BE ABLE TO GET THEIR FULL AMOUNT BACK.

This scenario has most recently occurred in Greece, Cyprus and even some investment funds in the UK after Brexit. It’s called a ‘bank run’ or ‘run on the banks.’

The whole idea of money and banking in general is quite shocking once you learn how it all works. But, if you understand how it operates, then you can navigate your way safely through most of the challenges.