Bank Deposits #primers

Bank deposits are are what constitute the vast majority of what people think of as “money” and what they store much of their wealth as. When you logon to your online bank account, you are simply seeing how many bank deposits you have — how much your bank owes you.

Unlike banknotes (cash), which constantly retain value so long as the government exists, a bank deposit can be thought of as an IOU from a bank. Of course, like with any IOU, it can be defaulted on and not repaid. They are created by the private sector, so they are not risk-free (unless in an amount less than $250,000, which the FDIC insures). Banking crises occur when a bank has made too many bad loans or investments and becomes insolvent. When that happens, a bank’s deposits may no longer be convertible to currency at par, so a $100 deposit may not be convertible to $100 in currency as depositors share in the loan losses. Depositors will panic and try to withdraw their deposits at the same time (bank run), accelerating the bank’s demise. They are therefore unsecured liabilities.

In the same way that bank reserves are created when the Fed buys assets or creates loans, bank deposits are created when a commercial bank buys assets or creates loans. A commercial bank does not lend out bank deposits, it creates bank deposits out of thin air (see this PDF for the details). So the commercial bank has to make sure its deposits are backed by sound loans and that it has enough liquidity to meet payments to other commercial banks.

Since commercial banks create deposits, they will have many more deposits than in bank reserves (today, $17 trillion in bank deposits versus $3 trillion in bank reserves). In practice, a commercial bank both receives and makes large volumes of payments each day. At the end of the day, the amount of reserves they have usually doesn’t change that much, so they only need to hold a small amount of reserves against the deposits they create. This is known as fractional reserve banking. Should the commercial bank have more outflows than anticipated, it can always borrow reserves from another commercial bank or from the Fed (via the Discount Window) to keep afloat.

#primers