How banks create money
In What money is we saw that most money is not cash but numbers in bank databases. This post follows those numbers: who writes them, under what rules, and what stops them from growing without limit.
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debit | credit (balance: ?)The textbook story, and why it is misleading
Many of us learned the money multiplier: you deposit 100, the bank keeps 10 as a reserve and lends out 90, the 90 gets deposited elsewhere, that bank lends 81, and so on. Banks are pictured as middlemen that pass savers' money on to borrowers.
In 2014 the Bank of England published a paper, Money creation in the modern economy, that said plainly this is not how it works today. The order is reversed: when a bank makes a loan, it creates a new deposit at the same moment. Lending comes first; the deposit is the result.
A loan, step by step
Look at the bank's balance sheet. Assets on the left, liabilities on the right. Everything must balance.
BEFORE the loan
+------------------------+------------------------+
| ASSETS | LIABILITIES |
+------------------------+------------------------+
| reserves 1,000 | deposits 9,000 |
| other loans 9,000 | equity 1,000 |
+------------------------+------------------------+
total 10,000 total 10,000
| the bank types two numbers
v
AFTER a 10,000 loan to Anna
+------------------------+------------------------+
| ASSETS | LIABILITIES |
+------------------------+------------------------+
| reserves 1,000 | deposits 9,000 |
| other loans 9,000 | Anna deposit 10,000 * |
| Anna's loan 10,000 * | equity 1,000 |
+------------------------+------------------------+
total 20,000 total 20,000
* new: an asset (her debt) and a liability (her money)The bank did not take 10,000 from anyone. It typed two numbers:
- an asset: Anna owes the bank 10,000 (plus interest);
- a liability: the bank owes Anna a 10,000 deposit she can spend.
That new deposit is money: she can pay a builder with it. Broad money in the economy grew by 10,000. When Anna repays the loan, the reverse happens and the money is destroyed. The money supply is a constant flow of creation (new loans) and destruction (repayments).
new loan spending repayment
+---------+ deposit +-----------+ deposit +------------+
| bank | ----------> | Anna | ----------> | builder |
| creates | +10,000 | pays bill | moves | ... |
+---------+ +-----------+ +------------+
^ |
|__________ loan repaid: deposit and loan vanish ___|So what stops banks from printing forever?
If loans make money, why don't banks lend without limit? Because several brakes act on them, and these are the real limits:
- Profitability and risk. A loan that isn't repaid is a loss that eats the bank's equity. Banks lend when they expect to be repaid with interest.
- Demand. Someone must want to borrow at the offered rate. In a recession, demand for loans falls even if banks want to lend.
- Capital rules. International rules (the Basel accords) require equity of at least a certain share of risky assets. Less capital means less lending.
- Liquidity rules. When Anna pays a builder at another bank, her bank must transfer real reserves to that bank. A bank must hold enough liquid assets to survive outflows.
- The price of money. The central bank sets the short-term interest rate, which ripples out to every loan rate. Higher rates mean fewer profitable loans and fewer willing borrowers.
Two kinds of money, two layers of banks
The system has two layers, and each has its own money:
+-------------------------------+
| CENTRAL BANK |
| issues: cash + RESERVES |
| sets: policy interest rate |
+---------------+---------------+
| reserves move only between banks
+---------------------+---------------------+
| | |
+-----v-----+ +-----v-----+ +-----v-----+
| Bank A | <-----> | Bank B | <-----> | Bank C |
| DEPOSITS | payments| DEPOSITS | | DEPOSITS |
+-----+-----+ settle +-----+-----+ +-----+-----+
| in reserves | |
households & firms hold DEPOSITS (bank money), not reserves- Reserves are money that only banks hold, in accounts at the central bank. Payments between banks finally settle in reserves.
- Deposits are what you and I hold: promises by a commercial bank to pay us central-bank money (cash or a transfer).
Your deposit is therefore a promise layered on another promise. Most of the time nobody notices the difference, because deposits are insured (up to a limit) and convertible one-to-one.
When the promise wobbles: bank runs
A bank keeps only a fraction of its deposits as cash and reserves. That's fine as long as only a few depositors want their money on the same day. If many come at once, even a healthy bank can't pay them all, because its assets are long loans that can't be sold quickly. That is a bank run.
day 1: [$][$][$][$][$] ... calm, a few withdrawals
day 2: rumour -> ( !! )
day 3: o o o o o o o o o o o o o o o o o o o <- the queue
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"first come, first served" makes waiting irrationalModern runs happen in hours, through phones. Silicon Valley Bank in March 2023 lost about $42 billion in deposits in a single day. Societies have built three defences:
- Deposit insurance, so small savers have no reason to run.
- The central bank as lender of last resort, lending reserves against good collateral to a bank that is solvent but short of cash.
- Supervision and capital rules, so banks are less likely to be insolvent in the first place.
Critics point out a cost. If the downside is insured and bailouts are likely, banks may take more risk. That problem is called moral hazard.
What the central bank actually does
Before 2008 central banks mainly steered one interest rate by adjusting the amount of reserves. After the 2008 crisis and again in 2020 they also bought large amounts of government and other bonds, paying with new reserves. This is quantitative easing (QE). It pushed long-term interest rates down and filled banks with reserves. Many countries, including the US since March 2020, now have no reserve requirement at all; rates are steered by the interest the central bank pays on reserves.
Views on QE divide sharply:
- Supporters say it prevented a depression.
- Critics say it inflated asset prices, helping those who already owned stocks and houses, and blurred the line between monetary policy and financing the state.
Debates worth knowing
- Full-reserve or "sovereign money" proposals (Switzerland voted on one in 2018 and rejected it) would stop commercial banks from creating money. Only the central bank would create it.
- Central bank digital currencies (CBDCs) would let the public hold central-bank money directly. People argue over privacy, over whether deposits would drain out of banks, and over how much the state could see.
- Stablecoins and crypto try to build a parallel ledger. They meet the same questions as banks: what backs the promise, and who covers a run?
Summary
loan --> deposit (new money) --> spending --> repayment --> destroyed
^
limited by: profit, demand, capital, liquidity, ratesCommercial banks create most of the money we use, by lending. Central banks don't control the quantity directly. They control its price and the plumbing, and they stand behind the system when it panics. Next: how these national systems connect into one world monetary order.