How do banks create money?

Intro: Do banks lend out your savings?

Why and how does a bank create money? Most people picture it like this. You put your money in a vault, and the bank lends it out to someone else. It's a tidy picture. It's also not how it works. When a bank makes a loan, it doesn't hand over someone else's savings. It creates brand new money, on the spot, with a few keystrokes.

Goldsmith receipts: how banking began

To see how that started, go back to London in the sixteen hundreds. Merchants stored their gold with goldsmiths, who had the strongest safes in town. In return, the goldsmith gave them a paper receipt. Soon people stopped bothering to fetch the gold. They just traded the receipts, because everyone trusted them. And the goldsmiths noticed something. On any given day, only a small share of the gold was ever claimed. So they started lending out extra receipts. More paper than there was gold in the safe. That was the birth of modern banking, and of money created by banks.

Loans create deposits

Today it's the same idea, minus the gold. Say you borrow money to buy a house. The bank doesn't go to a pile of other people's deposits and pass some along. It simply types a new deposit into an account, and at the same moment records your loan, the money you owe back. Two entries appear together, out of nothing. Your loan becomes the bank's asset. The new deposit is brand new money that can now be spent. Economists sum it up in three words. Loans create deposits. The Bank of England spelled this out plainly in a 2014 paper on how money is created.

97% of money is bank deposits

And this isn't a side detail. In Britain, the Bank of England estimated that about ninety seven percent of the money people use is bank deposits like these. Only a sliver is physical cash. Most of the money in the economy exists because a bank, somewhere, made a loan.

Repaying a loan destroys money

It works in reverse, too. When you pay a loan back, that money disappears. The deposit and the debt cancel each other out. So when lots of people borrow, the money supply grows. When lots of people pay down debt, it shrinks.

What limits bank lending?

So why don't banks just create unlimited money? Because they have real limits. A loan only makes money for the bank if it gets paid back, so bad loans eat into its profits and its capital. Regulators require banks to hold a cushion of their own capital against every loan. Banks need reserves to settle payments with each other every day. And above all, there's the price of borrowing. Interest rates.

How the Fed's interest rate reaches you

In the United States, the Federal Reserve sets a target for the interest rate banks charge each other overnight. That rate ripples outward, into mortgages, car loans and credit cards. When the Fed raises it, borrowing costs more, fewer people take out loans, and less new money gets created. That's how higher rates cool down inflation. When the Fed cuts rates, the opposite happens. And notice the old textbook story, where a bank must keep ten percent of your deposit and lends out the rest. In 2020, the Fed set that reserve requirement to zero. What actually holds lending back is risk, capital and interest rates.

Recap

So a bank doesn't lend out your savings. When it lends, it creates new money, and the real brakes are borrowers who must repay, regulators, and the price of money itself. ThatsWhyHow.