To follow money creation, it helps to distinguish a bank-account balance from central-bank money, which consists of cash and balances held at the central bank. A loan can add to the account balance without putting notes or coins into circulation.
The process is a sequence of account entries: lending creates a deposit, payments move deposits between customers, and repayment of the loan principal removes deposit money.
What Is Money Creation?
In modern economies, commercial banks create most deposit money by making loans.
Bank deposits are not the same as central-bank money. Central-bank money consists of cash and balances held at the central bank, while a customer’s deposit is held at a commercial bank.
In the United Kingdom, bank deposits made up 97% of broad money in December 2013. That figure shows how large a part of the money supply deposits represented at that time.
How Do Bank Loans Create Money?
When a commercial bank makes a loan, it creates a matching deposit in the borrower’s account. The Bank of England illustrates the process with a £100 loan credited to the borrower’s account.
The borrower can then use the balance to pay someone else, such as a seller. If the recipient banks elsewhere, the deposit moves to the recipient’s account and the banks settle the payment using balances held at the central bank.
This means banks do not simply lend out deposits that savers have placed with them. Lending itself creates a deposit; the payment that follows moves that deposit between accounts.
What Happens to the Money When a Loan Is Repaid?
When a borrower repays the principal of a bank loan, the deposit money created by that loan is removed from the banking system.
Banks can also create deposits by buying an asset from a customer and crediting the customer’s account. By contrast, when one non-bank lends money to another, the borrower’s deposit rises while the lender’s deposit falls by the same amount, leaving total deposits unchanged.
Money creation is not the same as wealth creation. A borrower receives a deposit but also takes on a matching debt.
Where Is Bank-Created Money Used?
Bank-created deposits can be used for ordinary payments, including a transfer from a borrower to a car seller.
A mortgage can create a deposit when a bank credits the borrower’s account with the loan amount. Businesses can also use loans to invest in equipment such as machinery.
In the United States, commercial-bank lending and bank purchases of securities from non-bank sellers can both create deposits.
What Limits How Much Money Banks Can Create?
Banks cannot create unlimited deposits through lending. Lending is limited by whether loans can be made profitably and by the risk that borrowers will fail to repay.
Banking regulation also constrains lending. Capital requirements, for example, require banks to have resources that can absorb loan losses.
Payments between banks matter too: when customers transfer deposits to other banks, the banks settle those payments using central-bank money. In normal times, central banks influence lending and deposit creation mainly through interest rates, rather than mechanically multiplying reserves into loans.
