How bank loans actually work

I don’t have a problem with a modest rate of interest for loans. The time rate of money is a real thing, and opportunity costs always exist. I have a problem with banks (and that includes credit card companies) charging exorbitant rates of interest for – nothing.

The money (most) banks lend doesn’t cost them anything except their normal operating expenses. They make the money up on the ledger books and credit your account with it. Funds ex nihilo. When you repay your loan, the funds return to nothing – except for the interest you pay, which is profit to the bank. From digital bits the loans were formed, to digital bits the loans are retired. Banks can lend infinite amounts of money, because the reserve ratio (how much they have on hand compared to how much they lend out) is currently 0%. To reiterate, the money the bank lends you doesn’t come from your neighbor’s savings accounts. It is made up out of thin air and keystrokes on a computer. The banks have, in effect, been allowed to print their own digital currency, in unlimited quantities.

“As announced on March 15, 2020, the Board reduced reserve requirement ratios to zero percent effective March 26, 2020. This action eliminated reserve requirements for all depository institutions.” 

When someone defaults on a loan, the banks actually loses nothing but the value of the interest not paid. The bank then writes off the default as a business loss, as if the money had been real. You see, on their books, the money loaned out (which came from nothing and nowhere, remember) becomes an asset, not a liability. So when you default, the value of the asset becomes a loss, the quarterly revenue is reduced on the books, and the bank pays a bit less in taxes.

Yes, this also means that when you pay back your loan, the bank’s assets decrease – except for the interest and fees you paid with real money, which is pure profit.

But what about the money in your savings account? Isn’t that also an asset? Of course it is. The reason it’s not readily available, despite the bank handing out loans from nothing at all, is that the bank uses 90% of your deposit money playing in the stock and bond markets. But that’s a different topic.