OPINION: How banks create new money by typing numbers on a keyboard 

Banks, they are our go-to place when we need money to buy new vehicles, houses, to pay for our children’s education or even for lobola.

But where do these infamous financial institutions get the huge sums of money that they lend to their customers every day? Is it from investors in the capital markets or from their shareholders like any other normal enterprise would raise its capital?

The short answer is no, but more on this later.

For now, it suffices to simply state that banks do not need to wait until they have raised enough capital before they can begin lending out money. Their liabilities (in the form of loans and deposits) always far exceed their equity. Their license issued by central banks is not only a regulatory measure but also allows them to create new money by simply typing numbers on the keyboard when they extent credits to their customers.

And despite their purported mandate of protecting the value of the currency and ensuring the soundness of the financial system, central banks are always privy to this money creation business that often happens without any corresponding economic activity. In addition to creating money out of thin air when they extent credits, banks also make a profit in the form of the interests paid by their customers on their loans.

While it might have exposed many politicians for the crooks they are, the collapse of VBS in South Africa and the subsequent revelation of the corrupt dealings by the masterminds who orchestrated bank’s demise also exposed the ineptitude and failure of the country’s central bank (reserve bank) in carrying out its constitutionally protected mandate.

Quantitative Easing

This was despite the reserve bank’s purported supervision private banks and a myriad of financial sector regulations and the formation of an independent regulatory body (the Prudential Authority) within the bank tasked with the mandate to enforce them. Be that as it may, and contrary to popular belief, the central bank’s money supply — sometimes via the bemoaned practice of Quantitative Easing is very negligible when compared to the “keyboard money creation” business of private banks.

I wrote an article sometime last month detailing how private banks rather the central banks play a principal role in inducing inflation and monetary instability in most economies across the world. This is the same article that my then publisher of over two years, the Free-Market Foundation (FMF) rejected because according to the organisation’s editor, its content was “not suitable for FMF content”.

My fallout with the FMF aside, let’s take a brief look at J.P. Morgan Chase & Co (the world’s largest bank by market capitalization as of 2023)’ structure to back up the claims made above. As of Q2 2024, J.P. Morgan had total assets of about $4.1 trillion and shareholders’ equity of $341 billion. If you crunch the numbers, you will see that the banks liabilities were approximately $3.759 trillion which far exceeds its shareholders’ equity.

These $3.759 trillion liabilities were made up of a total of $2.5 trillion in customers deposits and a $1.2 trillion loan portfolio, from which the bank made a net interest income of $22. 9 billion, thus benefiting from higher interest rates from those loans.

It should be clear by now that banks are the only businesses in the whole global economy which operate on liabilities from which they also make their income.

This business model explains why there are many entry barriers to the business of opening a bank.

Even if one eventually manages to satisfy all entry barriers and get the license to open and operate a bank, they will still be met with a myriad of expensive regulations which a new bank will find almost impossible to comply with.

The ultimately goal of these regulations seem to be keeping the average person out of this lucrative business of generating money from thin air. By way of an example, the Financial Times recently reported that the Federal Reserve has backtracked on its summer 2023 proposed capital requirements for large US banks and cut them by more than half after a backlash from the industry and politicians.

This was after months of lobbying by large US banks which put up billboards and ran television advertisements to warn of “dire consequences for everyday Americans”. For context, capital requirements in the banking sector are regulatory standards that dictate the minimum amount of capital banks must hold in relation to their risk-weighted assets.

Financial Cushion

These requirements serve as a financial cushion, ensuring that banks can absorb losses during financial downturns and maintain solvency without external assistance.

As further reported by the Financial Times, last summer’s proposal applied to banks with assets of $100 bn or more. Now, most of the rules no longer apply to those with less than $250bn.

The reader may ask, what’s all of this got anything to do with me? Well, for starters, the J.P. Morgan Chase structure outlined above is the structure of many private banks across the world including banks in South Africa. This model of banking makes banks more vulnerable and susceptible to bank failures.

And the problem with bank failures is that governments wind up pumping the failed bank with more taxpayer’s money arguing as it were, that they are “too big to fail” as was done during 2007-2008 Global Financial Crisis.

Sometimes the failure of banks also results in the loss of customers lifetime savings and deposits as was the case with the collapse of VBS in South Africa. Hence, the case I previously made for a system of “Pure Reserve Banking”. Under such a banking regime, banks would only offer safekeeping and payment services, and nothing else. Loans would be a function solely of capital markets, which would operate without government facilitation.

Lehumo Sejaphala holds a BA Law and LLB degree from Wits University and an LLM from the University of the Free State. He also runs an online blog platform called the Voiceless and has contributed articles to various media houses.