Bank money creation

How can commercial banks create spendable money when they make loans?

Most people picture a bank as a warehouse: savers bring money in, the bank keeps it safe and lends some out. Tidy — but test it against something you have watched happen. When a mortgage is approved, does a van arrive from another customer's vault? Nothing is fetched. A number appears in the seller's account and can be spent that afternoon. Where did that come from?

Follow the paperwork rather than the intuition. A bank writing a loan does two things in one keystroke: it records that you owe it, say, two hundred thousand — an asset — and credits two hundred thousand to your account — a liability, since it now owes you that on demand. Both entries are new. Nobody's balance went down. Ask what a bank deposit actually is and the puzzle dissolves: not stored cash, but the bank's promise to pay you. A promise is not scarce the way gold is. It can be written.

Then why is anyone's promise not money? Because you can only spend it where it is accepted. Bank deposits are accepted everywhere, so the promise circulates — and circulating promises are, for practical purposes, money. Nearly the whole money supply is of this kind; notes and coins are the small remainder.

If promises can be written, what stops a bank writing an infinite number? The textbook answer is the re-lending cascade. Someone deposits 100 into a bank that must hold 10 per cent in reserve. It lends 90; that 90 is deposited somewhere, and 81 is lent from it, then 72.90, then 65.61. Each round is nine-tenths of the last, so the total is a geometric series and it converges: 100 divided by 0.1, which is 1000. Deposits reach 190 after one round, 271 after two, about 409.5 after four, and creep toward the ceiling without touching it. Satisfying — and exactly where to be suspicious, because it still assumes the bank lends out something it received.

Does the constraint work that way? Central banks now say plainly that it does not. The Bank of England's 2014 bulletin on the subject calls the multiplier account a misconception: lending creates deposits, not the reverse, and reserves are supplied afterwards on demand rather than rationed in advance. Nor is the ratio always there to bind — the United States set required reserves to zero in 2020, and the United Kingdom has had none for decades.

So what limits it? Ask what a banker worries about. Whether the borrower repays. Whether the loan earns more than the deposit costs. Whether enough shareholder capital stands behind it to absorb losses, since capital rules bind where reserve rules no longer do. Whether it can settle the outflow when the borrower pays a customer of another bank. And above all whether anyone wants to borrow at the price of money the central bank has set. Those are the brakes — profitability, risk, capital and demand — not a stock of other people's savings.

Two things to hold onto. This is not a claim of fraud or concealment: it is ordinary double-entry bookkeeping done in the open, and the loan asset exactly matches the deposit liability — the bank has not made itself richer by the act, only larger.

And the process runs backwards too. Repay a loan and the deposit is debited while the loan asset is cancelled; that money ceases to exist. Money is created by lending and destroyed by repayment, which is why the money supply can shrink when households and firms pay down debt faster than they borrow.

• Why banks need reserves for settlement but not as a stock to lend from.
• Why quantitative easing added enormous reserves without a proportionate rise in lending.
• What full-reserve or sovereign-money proposals would change, and what they would cost.

Every term the collection defines is gathered in the glossary.