What backs credit cards?

Question

I'm admittedly a novice when it comes to finance, so this may be a stupid question...

Are credit cards backed by actual money?

To clarify, when I get approved for a credit card with a $10,000 credit limit, does that mean the bank sets aside $10,000 to back my line of credit? Or, is there some sort of cash pool to maintain a ratio of available cash to credit given? If so, where can I find the details of how that works and how it's regulated in the United States?

The reason I ask is I'm wondering what would happen when a bank doesn't have enough cash to back the credit it's lent out to individuals. Since most transactions are ultimately bank to bank, it would stand to reason that the ratio of cash to credit (for credit cards) could be rather large if banks were willing to lend credit to each other at low rates for credit card transactions beyond their available pool of funds. I just made that scenario up, so it could be totally off base, but thinking about it really has me wondering how it all really works.

Answer 1

Banks play a statistical game. Let's take the more general case: Suppose you deposit $10,000 in the bank. Does that mean that the bank puts your cash in an envelope and stores it in the vault? No. They loan the bulk of that money out to other people -- home mortgages, business loans, whatever. So what would happen if tomorrow all the depositors showed up at once wanting to withdraw their money? The bank doesn't have the money, it's all loaned out.

In practice, the bank knows that this isn't going to happen. Over time they've figure out what percentage of people are going to show up to withdraw money on any given day and how much they will withdraw. So they keep "reserves" adequate to handle any likely amount. Banks make arrangements with other banks so that if they get an unusual number of withdrawals one day, they borrow the money from another bank in an "overnight interbank loan". Note that the bank doesn't have to know when you specifically will withdraw money. They have many thousands of customers. They just have to know how much the AVERAGE customer will withdraw each day.

A hundred years ago, if many people tried to withdraw their money all at once from many different banks, the system broke down. This was called a "run". It's part of what went wrong during the Great Depression. Today the government guarantees most deposits, so if your bank really does run out of money, the government will make it good. There will be a delay while they go through all the paperwork, but you'll get your money.

Getting back specifically to credit cards: If you have a $10,000 credit limit, the odds that you will go and run up to that limit tomorrow are small. The bank knows how much the average customer will spend each day and how fast they will pay it off, so they can keep sufficient cash on hand to pay any charges.

Oh, and when I say "cash" here, I don't mean necessarily green paper and coins. Most of the cash in the US today is electronic money, that is, the bank just has stored on their computer somewhere that you have $X. If you pay for something with a check or debit card, they don't take green paper out of your envelope and mail it to the store. They subtract from the number stored on the computer for your balance and send a message to the store's bank telling them to add to the number for the store's balance. If you pay for something with a credit card, they add to the amount you owe and send a message to the store's bank to add to the amount in their balance.

Answer 2

The simple answer is, credit cards are not directly backed by cash. Banks do not put aside cash to back cards, or even deposits. A bank extends credit because it is a low risk way for the bank to make money from interest. Banks do keep a certain amount of money on reserve for those wishing to withdraw money, but it is far from enough to account for every dollar deposited. A large bank only needs about 10% of its assets to be liquid by law.

When you use your credit card, it's kind of like you are spending other peoples money who have deposited their cash in the bank. The bank takes deposits and lends them out to make money on those deposits.

Hope this answers your question!

Answer 3

Credit cards are in essence just a frame contract for very flexible loans. As long as you don´t use them, nothing really happens.

Every time you pay something with them, you are basically creating a new loan.

Now how does a loan work? Does the bank have an actual stash of cash somewhere, where they subtract your amount and hand it out to you? - No!

They do not, as some of the other posts suggest, hand you the money that other people deposited there. They just 'create' that money for you by creating a debt and a corresponding deposit, which you then spend on your transaction.

To limit that creation of money, they have to have a certain amount of securities as reserve - in the US currently 10 %.

So no, if everybody wanted max out their credit limit at once, the bank could usually not deliver within the reserve rules (although it may be able to increase reserves by inter-bank loans etc.)

Also, if everybody wanted to withdraw all their deposits, it would not be able to deliver. If you want to know what that looks like, look at Greece a few years back.

For further reading I suggest you start with the article Fractional Reserve Bankng

Answer 4

Let’s say you used 8000 of your 10000 credit and try to buy an item for 5000 - the purchase will fail because you don’t have enough credit. Now say you used none if your credit, you want to but an item for 5000, and hypothetically your bank ran out of money. All that would happen is that your purchase fails.

See the other answers for why this will not happen in practice.