When you go to a bank to borrow money, you might think that the bank gives you money that other people deposited. That’s what a lot of people believe, but it’s not quite how it works. In this article, I will explain how banks are in the unique position to create money by issuing (giving out) loans, and reflect a little on its implications.
Lending money on a balance sheet
To understand a bank’s money-creating superpower, I will illustrate some examples using a simple balance sheet.
A balance sheet shows what you own (assets), what you owe (liabilities), and the difference between them, which is your equity or net worth. Assets include things like cash, investments, and property, while liabilities are debts like loans and credit card balances. Your equity is what’s left over after you subtract what you owe from what you own—essentially, it’s the value that’s truly yours. As the name suggests, the amount of assets is always balanced by the amount of liabilities.
Let’s say I own $1000 in cash and owe nothing to anyone else. My balance sheet would look like this:
my balance sheet
| assets | liabilities |
|---|---|
| $1000 cash | $1000 equity |
| total: $1000 | total: $1000 |
My net worth is $1000, which I happen to own in cash.
Let’s now say I borrow $1000 to a friend. This basically entails giving my friend $1000 in cash in exchange for a promise (worth $1000) to repay me. In my balance sheet, we see the following change:
my balance sheet
| assets | liabilities |
|---|---|
| $1000 loan | $1000 equity |
| total: $1000 | total: $1000 |
As you can see, my total assets and liabilities remain unchanged: my net worth is still $1000, but now I own it in the form of a loan.
For my friend, the balance sheet will look a little different. He now owns $1000 cash (asset), but is also $1000 in debt with me (liability):
friend's balance sheet
| assets | liabilities |
|---|---|
| $1000 cash | $1000 loan |
| total: $1000 | total: $1000 |
While assets and liabilities are still in balance, my friend’s balance sheet has lengthened from taking the loan. Together, however, we still posses only $1000 cash.
Creating money
Let’s now assume that I am unable to lend my friend $1000, and he decides to take a 0-interest loan at a bank instead.
The bank now gets the $1000-dollar loan that I owned previously, but instead of handing my friend $1000 in cash, the bank provides him with a $1000 deposit (a liability for the bank, an asset for my friend).
bank's balance sheet
| assets | liabilities |
|---|---|
| $1000 loan | $1000 deposit |
| total: $1000 | total: $1000 |
friend's balance sheet
| assets | liabilities |
|---|---|
| $1000 deposit | $1000 loan |
| total: $1000 | total: $1000 |
In comparing these balances to those of me lending my friend the money, we observe something interesting. Instead of losing $1000-worth of cash, the bank simply adds a $1000 deposit to its liabilities. The bank has effectively added $1000 to the money supply by reclassifying ‘negative cash’ as a customer deposit.
As my friend might want to withdraw the deposit, the bank needs to have some reserves of actual (or cash-backed) money. However, since there is a constant in-and-outflow of thousands of deposits and loans, this only needs to be a fraction of the total deposits’ value. Not surprisingly, this banking practice has therefor been called fractional reserve banking.
Why it works
If I’d stop here, a sensible response would be to throw up your hands in confusion wondering how our banking system still hasn’t collapsed. (Or, maybe more importantly, how such a practice is allowed in the first place.)
However, when we look a little further ahead in time, it may not seem so strange after all, and perhaps even a logical strategy to pursue.
So, let’s continue the story of my friend that took a $1000 loan. After getting the loan, he goes straight to the ATM to empty his deposit. On the bank’s balance sheet, this would have the following effect:
bank's balance sheet
| assets | liabilities |
|---|---|
| $1000 loan, -$1000 cash | $0 deposit |
| total: $0 | total: $0 |
By paying out the deposit in cash, you could say that the bank has essentially transferred the value it had previously created.
Knowing he’d have to return the loan by the end of the year, my friend decides to buy a $1000 cargo bike to drive around people for cash. His balance sheet now looks like this:
friend's balance sheet
| assets | liabilities |
|---|---|
| $0 deposit, $1000 bike | $1000 loan |
| total: $1000 | total: $1000 |
With fierce dedication, he drives around people for a year and earns exactly $1000 for his efforts. Let’s say he only took cash payments while doing so; the balance sheet is lengthened, and my friend has a net worth of $1000:
friend's balance sheet
| assets | liabilities |
|---|---|
| $0 deposit, $1000 bike, $1000 cash | $1000 loan, $1000 equity |
| total: $2000 | total: $2000 |
Paying back the loan with his earnings, his net worth remains $1000, which he owns in the form of the bike.
friend's balance sheet
| assets | liabilities |
|---|---|
| $0 deposit, $0 cash, $1000 bike | $1000 equity |
| total: $1000 | total: $1000 |
Furthermore, by paying off the loan, the bank loses its negative cash balance in exchange for the loan, reducing the overall balance to 0:
bank's balance sheet
| assets | liabilities |
|---|---|
| $0 loan, $0 cash | $0 deposit |
| total: $0 | total: $0 |
The artificial $1000 value initially created by the bank has now been converted to real value for my friend in the outside world.
The nuance that this second part of the story tells us is that in essence, the bank is creating artificial value now to enable a borrower to create real value in the future. Provided that the loan can be paid back eventually, this seems like a great mechanism to continuously create value in an economy.
The only factor constraining the amount of value that can be created this way is the fraction of reserves a bank needs to maintain to remain able to meet the occasional peak in cash withdrawals. As failing to meet this requirement can have wide-spread effects on the economy and people’s savings, this rate is carefully set by the central bank.
Great power without great responsibility
Money makes the world go ‘round, so the power to make money appears to be a significant one. Indeed, central banks, who create money directly by printing and issuing cash, are heavily regulated. The Federal Reserve in the U.S. or the European Central Bank (ECB), have strict rules and criteria regarding which institutions can access central bank lending facilities. These regulations are in place to ensure the stability of the financial system, prevent excessive risk-taking, and protect the broader economy.
Werner (2014) argues that “the privilege to create money is a public prerogative” [p.77]. Should such a public prerogative be allowed to serve commercial interests? Shouldn’t the lending constraints central banks have to abide to apply to commercial banks as well?
Seeing how banks continue to finance industries that destroy our environment and harm the public they were enabled to serve, these appear to be vital matters to address.
I was inspired to write this article after reading a 2014 paper by Richard Werner titled: How do banks create money, and why can other firms not do the same? For a more detailed exploration of the topic, I highly recommend checking out his work. You can access the paper by clicking the icon of this box.
