Banks, central banks and interest rates — how the system really works

Commercial banks create money

When you deposit money, you are lending it to the bank — legally, it becomes the bank's money and you hold a claim on it. And when a bank makes a loan, it does not hand out other people's deposits: it creates a new deposit for the borrower. As the Bank of England put it in 2014, most money in a modern economy is created this way, by commercial banks lending.

Banks hold only a small fraction of their deposits as reserves, and fund themselves with relatively little equity. That makes them efficient — and fragile. If many depositors want their money at the same time, or many loans go bad, a bank can fail within days, as Silicon Valley Bank did in March 2023.

Deposit insurance covers the first $250,000 per depositor per bank in the US and €100,000 in the EU. Above that, a deposit is an unsecured loan to a bank. Securities such as shares and ETFs held at a broker are different: they are your property, held separately from the broker's own assets.

Central banks set the price of money

Central banks such as the Federal Reserve and the European Central Bank aim for stable prices (about 2% inflation) and, in the US, maximum employment. Their main tool is the short-term interest rate:

• Lower rates make borrowing cheap, support spending and investment, and push up the prices of assets.
• Higher rates cool the economy and inflation — and pull asset prices down.

In crises they go further: quantitative easing means the central bank buys bonds with newly created money to push long-term rates down and keep markets functioning.

Why interest rates move every market

The value of any investment is the value of its future cash flows today. When rates rise, future cash flows are worth less — so bond prices fall, and stocks, property and other long-duration assets come under pressure. When rates fall, the opposite happens.

The 2022 rate shock shows it clearly: long-term US Treasuries — usually seen as the safest asset — fell almost by half from their 2020 high, more than stocks did.

Related: the economic cycle · liquidity · macro

By Dr. Harry Hamann · 6 min read