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Money Creation

Money Creation

Did you know that money can be created out of thin air? That's right, all that effort in studying and climbing the corporate ladder for a better wage isn't necessary! Banks create money all the time; they offer loans to borrowers for more money than they actually have! Unfortunately for us, though, only banks can create money, so don't resign from your job. How exactly do they create more money than physically exists? We'll answer that question and more in this explanation of money creation, so read on!

Money Creation Formula and How Money Multipliers Work

Ready to learn the formula for money creation? It is all about how money multipliers work. In our modern economy, there is a multitude of interweaving systems that allow for magical things to occur, like money creation! Money creation is a phenomenon that occurred when banks were in their early founding days. Banks were initially used as convenient places to store assets.

Money Creation A drawing of a man sitting on a safe with money bags next to it StudySmarterFig. 1 - Banker storing money in a safe

Bankers realized that the people storing their assets did not come to collect the entirety of their savings, and some rarely withdrew for years. Because bankers had many people's savings piling up, they realized they could put them to use. This became the discovery of the formula for money creation, though there isn't an actual mathematical formula. The formula requires multiple banks to engage in lending activities. This creates a money multiplier that increases the quantity of money more than was previously in circulation.

For more details on the money multiplier, consider reading our explanation of it.

It may even help you multiply your money one day!

This gave rise to the concept of lending, providing a loan to a customer in exchange for them paying you back more than the initial loan. By lending out others' money, under the assumption that depositors won't collect it soon, banks were able to create more money than presently existed, an early instance of money creation.

Money Creation occurs when financial institutions lend accumulated savings in exchange for a greater repayment at a later date.

Maybe the concept of money creation doesn't make sense yet; aren't they just giving away other people's money without asking? Yes, technically, they are, but as long as the public believes the bank will make good on its ability to pay when it's needed to, then it can go on creating money. Let's clarify this concept with an example:

Meg walks to the bank and deposits $1,000 so she doesn't have to sprint around with it. Claudette is hiding in a bush outside the bank and sees Meg make the deposit. Claudette needs some money to pay a debt she owes to Zarina, who previously helped her get back on her feet. The bank gives Claudette some of Meg's money, loaning $900 of it to Claudette. Claudette pays it all to Zarina. Normally, Zarina keeps it off the record, but she decides to put the money into a bank. Now the bank has $1,900 deposited into it.

In the example above, the bank had an initial deposit made by Meg. The bank then created more money by loaning a portion of it out, which was given to Zarina, who deposited it into the bank. Though the bank has $1,900 deposited into it, it only has $1,000 on hand and $900 owed by Claudette. All banks engage in a process like this. While the bank can't make a loan with the original $1,000 until the loan is paid back, they can make a loan from a percentage of the $900 that Zarina deposited.

Money Creation in the Modern Economy

To understand money creation in the modern economy, we must first establish principles and terms for banking. Banks generally operate on what's known as a fractional reserve banking system. This allows them to maintain a regulated quantity of available funds and give out the rest to borrowers. A reserve requirement is dictated in the United States by the Federal Reserve.

For more details on the Fractional reserve system, check out our explanation of it!

The fractional reserve banking system allows banks to give out depositors money as loans as long as they maintain the regulated reserve requirement.

This balance between lending and holding deposits is noted in a sheet, a balance sheet! A balance sheet has two sides, assets and liabilities. Assets are the monetary value of things owned or payments that will be coming in. For banks, assets are predominantly loans and cash on hand. While liabilities are generally deposits made into the bank, that is to say, the bank owes its depositors what they put in.

The balance sheet logs all transactions in a specific manner. If a bank has $1,000 in cash assets and it then provides a loan to a citizen for $1,000, it removes the $1,000 cash asset and creates a liability worth $1,000. However, for the sheet to balance, it also creates an asset, that asset being the eventual payment of the loan, worth $1,000.

Because banks provide loans using the money of depositors, technically, they are unable to pay the depositors if they all withdraw at once. If you heard that a bank can't pay people their deposits, would you run to the bank to get your money out before it's gone? That scenario is called a bank run, where a panic occurs that the bank will be unable to pay its depositors, and depositors fear losing their savings. The problem here isn't the bank being able to pay (although partially); the real problem is belief in the bank's ability to pay.

Ironically, it would make sense to believe that the required reserve ratio is meant to prevent a bank run; however, it's not. It's actually meant to mitigate how much risk banks take on. To prevent bank runs, governments establish a form of deposit insurance. In the United States, it's the FDIC (Federal Deposit Insurance Corporation). The FDIC will compensate depositors for $250,000 per bank if a bank is unable to pay what it owes.1

Money Creation by Banks

Banks engage in money creation by acting as lenders to the public. When individuals or businesses need money to engage in action but can't afford it, they turn to banks. Lending provides a powerful economic tool that enables innovation and investment in production.

You are paid to dig holes for your grandma's garden, but you have no starting money. So first, you must dig holes with your hands until you have enough money to buy a shovel. The shovel allows you to dig holes much faster. Banks can enable the shovel to be purchased without any money through lending. Making it, so you wouldn't have to dig the holes with your hands.

Ironically, taking on loans and debt from a bank is also considered digging a hole, just financially.

Through lending actions like the ones described above, banks allow economic actors to skip financial barriers that would slow their progress. This happens in exchange for dealing with the financial barrier over time or at a later date. So how much do banks actually loan out to spur the economy?

According to the Federal Reserve, in August 2022, commercial banks held $20,789,500,000,000, or 20.7 trillion dollars in liabilities, which are mostly deposits held by banks. Commercial banks also hold $22,951,600,000,000 or 22.9 trillion dollars in assets, which are various forms of loans.2

Money Creation Illustration of a piggy bank and charts StudySmarterFig. 2 - Piggy bank finances

A reserve requirement is a tool manipulated by the Federal Reserve to keep the economy stable. However, since the global pandemic in 2020, stability has been rare. The Federal Reserve set a new threshold in response to the pandemic. The Federal Reserve set the reserve requirement to 0%. In the belief that the economy can use all the stimulus it can get to induce money to circulate the economy, the reserve requirement was temporarily removed.3

For an in-depth explanation of bank reserves, read our explanation on it!

What happens when banks create too much money?

In 2008, a global financial crisis happened as a result of high-risk lending that occurred predominantly in the housing and mortgage markets in the United States. Mortgage-backed securities were a very popular source of investment, so bankers had the incentive to provide more mortgages. However, banks were running low on individuals to take out mortgages, so they lowered their standards for loan qualification. Sub-prime mortgages, or mortgages given to high-risk borrowers, occurred. The market frenzy on mortgage-backed securities and increased demand from subprime borrowers skyrocketed home prices. Increased home prices made it harder for risky lenders to pay their mortgages. Borrowers started defaulting, and home prices dropped rapidly, which led investors to cease buying mortgage-backed securities. Financial investors had to declare bankruptcy as their asset values plummeted. This led to a drop in all investments, which swept the country and, eventually, the world.

Assumptions of Money Creation

To view money creation in a vacuum, three main assumptions must be put in place.

  1. The reserve ratio for all commercial banks is 10%

  2. At the start, all banks are exactly meeting the reserve ratio, with no excess reserves.

  3. If any bank acquires excess reserves, it will immediately loan out the entire amount. The borrower will pay a debt, and that debtor will deposit the entirety of the loan into another bank.

Money Creation Example

A great way to understand money creation in action is to view an example.

Table 1 below demonstrates how an initial deposit of $500 allows banks to loan their excess reserves. When this cycle repeats through multiple holders and banks, the same $500 creates much more economic opportunity.

A loan is taken from the Cheddar bank by person A and is paid to person B, who deposits it into the Gouda bank, etc.

Bank
Acquired Reserves and Deposits
Required Reserves
(Reserve Ratio=10% or .1)
Excess Reserves
Funds Given as Loans
Cheddar
$500
$50
$450
$450
Gouda
$450
$45
$405
$405
Monterey
$405
$40.5
$364.5
$364.5
Parmesan
$364.5
$36.45
$328.05
$328.05

Table 1 - Money creation across multiple banks example

Table 1 above is an example of money creation by banks. One bank receives an initial deposit, which they loan a percentage out, and each following back does the same, resulting in a money multiplier. The scenario started with only $500; however, after, it was used to create several loans, thereby resulting in much more money in circulation.

\(\hbox{Money Created}=\$450+\$405+\$364.5+\$328.05=\$1,547.55\)

It's important to note that the initial depositors' $500 still exists and is collectible. The money created by the multiplier is in addition to that. Another factor is that this example stops early. Theoretically, the money can move to any number of banks and continue the multiplier effect over and over.

Money Creation - Key takeaways

  • Banks engage in money creation by leveraging their assets to provide loans to others.Banks are obligated to pay the depositor but lend the depositors' money out while they are not using it.
  • Money creation can only occur if there is a belief in a financial institution's ability to pay its debts.
  • The reserve requirement isn't meant to prevent bank runs but to curtail excessive risk-taking by banks.
  • The FDIC is deposit insurance to quell depositors' fears of losing their money if a bank was to default.

References

  1. The Federal Deposit Insurance Corporation (FDIC), Deposit Insurance FAQs, https://www.fdic.gov/resources/deposit-insurance/faq/index.html
  2. The Federal Reserve, Assets and Liabilities of Commercial Banks in the United States - H.8, https://www.federalreserve.gov/releases/h8/current/default.htm
  3. The Federal Reserve, Policy Tools, Reserve Requirements, https://www.federalreserve.gov/monetarypolicy/reservereq.htm

Frequently Asked Questions about Money Creation

Money creation occurs when banks take on risk by loaning depositors' money to borrowers, allowing the money to be both owed to the depositor and spent by the borrower.

Money creation refers to the additional dollars created by lending practices of commercial banks. Banks give depositors' money to borrowers, creating at least two instances of value from one money source.

Money creation enables economic growth and investments in production to occur exponentially faster than if everyone had to pay full price in real dollars up front. How many home buyers can afford the entirety of their house all at once?

Money creation is controlled by government regulation that controls risk financial institutions take on. Governments also provide deposit insurance to assure depositors they will not lose their money.

Money creation in an economy refers to when the circulation of a dollar creates more value than a dollar. This occurs when banks lend money to borrowers, as the money both exists for the borrower to spend and the depositor to withdraw simultaneously.

Final Money Creation Quiz

Question

______ __________ are the amount of money banks hold in the vault plus the amount in deposits they have at the Federal Reserve Bank.

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Answer

Bank reserves 

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Question

When banks discover that their cash reserves are less than the projected financial needs, particularly if they are less than the statutory minimum, they will seek money from other financial institutions with excess reserves.

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Answer

True

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Question

Banks lend money to consumers depending on the percentage of their ________ cash.

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Answer

available 

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Question

What's it called when the government requires the banks to retain a particular number of assets on hand to meet any withdrawals?

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Answer

Required reserves

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Question

Reducing the reserve requirement _____ funds into the economy by providing banks with extra reserves.

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Answer

injects

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Question

What happens when banks have extra reserves?

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Answer

The excess reserves encourage bank credit availability and lower interest rates.

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Question

How do banks with excess reserves lose money by holding onto it?

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Answer

Banks that retain excessive money on hand miss out on the extra interest that may be made by lending it.

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Question

There are three main types of bank reserves: required, excess, and legal.  

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Answer

True

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Question

In what way do excess reserves provide additional protection?

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Answer

They give financial security in the case of loan losses or big money withdrawals by consumers.

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Question

Banks generate revenue by accepting consumer ______ and then lending that capital to someone else at a greater rate of interest. 

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Answer

deposits 

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Question

The reserve ratio may be utilized to determine the minimal cash reserves, which are typically set as a predetermined percent of a bank's deposits.


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Answer

True

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Question

How are the reserves created in the first place?

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Answer

The central bank generates reserves by purchasing government bonds from commercial banks, and the banks can then use that money to make loans.

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Question

Who holds the reserves?

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Answer

Commercial banks hold required reserves while the central bank holds excess reserves.

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Question

Banks may be enticed to lend more funds than they ought to if reserves are not held.

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Answer

True

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Question

What is a fractional reserve banking system?

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Answer

A fractional reserve banking system is a banking system in which banks keep a part of client deposits as reserves while using the remainder to make loans to other customers. 

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Question

Fractional reserve system definition in economics refers to a banking system in which banks are required to keep ________ of their checkable deposits in their reserves. 


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Answer

A portion 

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Question

You have $40,000 in your savings account. Another consumer has approached the bank in hopes of borrowing $36,000. The bank can use the money you have in your savings account to make the $36,000 loan that the other consumer demands. 

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Answer

True

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Question

Fractional reserve banking system is monitored by the ___________.

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Answer

Federal reserve

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Question

___________ ensures that all the banks keep a set percentage of their total deposits in their reserve.

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Answer

The Federal Reserve

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Question

What is the reserve requirement ratio?

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Answer

The reserve requirement ratio is the portion of client deposits banks must keep in their reserves.

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Question

When the Fed __________ reserve requirement ratio, money supply increases.

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Answer

lowers

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Question

When the Fed __________ reserve requirement ratio, money supply decreases.

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Answer

increases

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Question

What are the main functions of the Federal Reserve System?

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Answer

The three primary functions of the federal reserve system are monetary policy, supervision and regulation, and services to depository institutions.

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Question

The function of the Federal Reserve's _____ _____ is to foster economic development, lower the unemployment rate, and encourage appropriate balance in the nation's trade with other countries. 

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Answer

Monetary policy

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What are some of the services the Federal Reserve offers to other depository institutions?

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Answer

Moving money, giving cash, taking deposits, and protecting deposits.

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Question

What are two main characteristics of the fractional reserve banking system?

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Answer

Money creation and banks' vulnerability to panic.

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Question

Why banks are vulnerable to economic crises?

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Answer

Because banks create loans even if they don't have the necessary funds to cover these loans.

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Question

Money creation in a fractional reserve banking system is due to the ability of banks to keep a portion of deposits in reserves and use the rest to create loans. 

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Answer

True

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Question

What are the three main factors that limit bank's ability to create money?

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Answer

The amount of cash in deposits

Reserve ratio 

Default risk

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Question

When individuals deposit less money, banks can create more money.

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Answer

False

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Question

What is money creation?

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Answer

Money creation occurs when banks owe depositors, but lend the owed money to borrowers. This allows the same money to exist in at least two instances.

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Can individuals engage in money creation?

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Answer

No, only established financial institutions with trust of their depositors can engage in money creation.

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Question

What happens if depositors try to withdraw, but a borrower has their money?

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Answer

If a bank is unable to pay a depositor, then panic will spread that all depositors will lose their money, creating a bank run.

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Question

What is a bank run?

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A bank run occurs when depositors "run" to the bank to take their money out all at once, and the bank doesn't have the reserves to pay all its depositors.

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How important is belief in a bank's ability to pay?

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Answer

Very important, banks leverage their assets to create as much money as possible. This can only occur if depositors trust they won't lose their money.

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Can a bank hold more money than physically exists?

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Answer

Yes, loans are created using existing deposits. The loans pay others, who then deposit the money in the bank. Allowing both the initial deposit and the loaned deposit to exist.

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Question

What is a fractional reserve banking system?

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Answer

A fractional reserve banking system requires banks to maintain a percentage of their assets, to curtail risk.

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Question

What is a reserve requirement?

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Answer

A reserve requirement is a minimum number of assets financial institutions must hold per regulation.

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Question

Can a reserve requirement ever be zero?

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Answer

In 2020 in the United States, the Federal Reserve set the reserve requirement to 0% to spur investment in response to the global pandemic.

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Question

What are the two categories on a balance sheet?

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Answer

Assets and Liabilities.

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Question

Identify how the following would appear on a bank's balance sheet:
A depositor is owed $1000 they put in a bank.

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Answer

Asset.

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Question

Identify how the following would appear on a bank's balance sheet:
A borrower owes a bank $1000 for a loan.

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Answer

Asset.

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Question

How can a bank engaging in money creation increase production?

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Answer

Money creation allows businesses to invest in more efficient production methods without necessarily being able to afford the required elements.

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Question

Was the 2008 financial crisis a result of banks engaging in money creation?

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Answer

Yes, money was created through loans given to risky investors who inevitably defaulted.

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Question

What is the quantity of money available for a bank to loan called?

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Answer

Excess Reserves.

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Question

How much does the FDIC insure depositors for?

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Answer

$250,000 per qualifying bank.

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