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How banks create money

By Samuel Alemu

“Banks are allowed to loan USD 10 for every dollar they actually possess, which means that 90 percent of all the money in our bank accounts is not covered by actual coins and notes.” (Harari, 2015).

How is it possible? How do banks create money? The question itself sounds simple. Everyone knows that governments print banknotes and produce coins to satisfy the growing demand for money in the economy. Whenever governments decide to print more money or produce more coins, it is a bad sign for the entire economy. However, one should not think that only governments create money. In reality, banks fulfill one of the primary functions of this process. Statistically, most money circulated in any economy is created by banks. Banks create money using a diversity of instruments, including but not limited to loans and services provided to individuals and corporate clients.

To understand how banks create money, it is crucial to understand what money is. According to (Harari, 2015), money is based on two universal principles: universal convertibility and universal trust.  The economic definition of money suggests that it is a medium of exchange.

In the 21st century, the concept of money cannot be limited to traditional currency banknotes and coins. With the rapid advancement of technologies, cash is quickly becoming obsolete, giving place to financial accounts and credit cards. This is why Sloman (2012) says that money is mostly a combination of bank accounts and book records kept by banks to keep themselves running. It would be fair to assume that money comes in a diversity of forms to fulfill several major functions while ensuring the stability and fostering growth in the economy.

A popular assumption is that banks create money out of thin air (Coppola, 2017). It has some truth to it. After all, banks do not produce any goods that could be sold for money. However, they provide a whole range of services to clients, and these services are not provided for free. Banks also assume responsibility for maintaining the integrity of their clients’ accounts and savings, and these services also have their price. Nevertheless, it is banks that have managed to create the bulk of money in the modern economy.

Statistically, banks are central to creating money in the economy. According to Positive Money (2018), within the first 300 years since the Bank of England was created, the financial system has managed to create trillions of dollars. Moreover, the pace of money creation in the global economy rapidly accelerated. For example, it took 300 years to produce the first trillion, and only 8 years to produce the second one (Positive Money, 2018). Today’s banks resort to a variety of instruments to make money.

Primarily, these are loans. Banks are entitled to keep a tiny share of money in deposits; they are free to lend their money to individuals and corporate clients. The amount of money circulating in the economy depends on the effectiveness of banking and financial operations, which increase the amount of credit money and make it more easily available to users. The more loans banks give, the more money they create. On the one hand, debtors should pay interest on the money they owe to banks. On the other hand, any loan provided by one bank automatically lands on a deposit account in another bank; this deposit money translates into another loan, creating a multiplier effect in the economy. Given the growing number of banks, even a single bank loan can produce a chain reaction, which ultimately increases the supply of money in the economy.

It is possible to assume that banks act as authorized intermediaries between the client and the economy. According to Coppola (2018), the accounting law of double entry explains how exactly the act of lending a certain sum of money translates into an even greater sum of money in the economy. When banks lend money, they create both an asset and a liability. As a result, every single loan increases banks’ balance sheets (Coppola, 2018). With these assets and liabilities at hand, banks can invite more clients to receive additional loans. With the growing amount of money lent to clients, banks increase their balance sheets to the point where they have enough assets to back up their operations and earn enough in credit interest to cover their expenses.

The problem with many banks is that they often fail to set limits on their lending operations. “Easy money” that start pouring into banks create a situation when owners and financial executives cannot stop. Before the crisis of 2008-2009, some banks had most of their balance sheets made of debt rather than deposits (Coppola, 2018). As a result, it took a shift in the real estate and asset markets to send those into bankruptcy. Today’s banks create money in accordance with the policies, requirements and limitations imposed on them by the government. Countries and economies do not want to face another debt crisis. However, they are more than willing to extend the role of banks in creating money.

In conclusion, banks create money through loans. The law of double entry implies that, whenever banks lend their money to an individual or corporate client, their balance sheets increase. Besides, they also earn interest. A loan given to a person or a company produces a chain reaction. The money taken from one bank lands on a deposit account in another bank. The more loans banks give, the more money they create, according to the multiplier effect. One should not think that this money comes out of thin air. After all, banks perform complex operations to maintain the continuity and integrity of their operations. They act as authorized intermediaries among multiple economic players, and money is the desired outcome of these interactions.

 

Ed.’s Note: Samuel Alemu is a partner at the ILBSG, LLP. His partner at the ILBSG, LLP, Praveen C. Medikundam, contributed to this article. They are both admitted to the bar associations of New York State, United States Tax Court, and the United States Court of International Trade. Samuel can be reached at [email protected]. You can follow Samuel on twitter @salemu.