How a commercial bank creates money when it makes a loan.

382 views

I don’t get it. I don’t get it. I don’t get it. I don’t get it.

When a bank makes a $1,000 loan, that creates $1,000 in the recipient’s account, but I don’t get how the loan, the absence of money, is an asset on the lending bank’s books. If it’s because the money will be paid back, then isn’t it’s value based on a corresponding debit of the recipients account thus nullifying the created money?

Edit: I am not asking how banks make a profit. I get that. I am asking how NEW DOLLARS are created. There are more dollars in existence now than there were say 100 years ago. I want to understand how they came to be. The answer I’ve found so far is that NEW DOLLARS are created when a commercial bank makes a loan.

Second Edit: For those saying commercial loans don’t create new dollars, apparently they do, but I don’t get it. For reference:

https://positivemoney.org/how-money-works/proof-that-banks-create-money/

In: 23

34 Answers

Anonymous 0 Comments

[deleted]

Anonymous 0 Comments

You are missing the concept of interest. When you take out a loan from a bank, you are not only promising to pay them back, but also to pay them more than what you originally borrowed in the first place. The longer it takes you to pay them back, the more you generally have to pay in addition to the original amount.

So many banks are able to make lots of money by giving people loans, and then those people pay back the money and more. And even if some people aren’t able to pay back their loans, enough are that banks make lots and lots of money this way.

Anonymous 0 Comments

Banks are loaded, dude.

They’re lending against assets that they have.

The entire premise of a bank is that a bunch of people pool their money together, and while the bank guarantees that that money will always be available to the rightful owner, they’re also turning around and lending it out to borrowers.

That’s why it’s always a problem when there’s a run on a bank… everyone trying to withdraw their money at the same time. That means that bank could actually not be able to give everyone their money back, and potential put the bank out of business.

In simpler terms, if Joe keeps $25,000 in his savings account, then the bank can lend Sally $15,000 of it for a car loan. But if Joe decides to close his account just after Sally opens her loan, then the bank just pays Joe money from Tom, Chris, and Darlene’s accounts. Then repays them with Sally’s loan payments.

And that’s not to mention the massive amounts of profits banks turn on interest payments and other service related charges and fees.

Anonymous 0 Comments

[deleted]

Anonymous 0 Comments

> If it’s because the money will be paid back, then isn’t it’s value based on a corresponding debit of the recipients account thus nullifying the created money?

Well, yes, until they withdraw the loan amount and spend it. At that point their account balance is zero so that liability is removed. A loan where the borrower hasn’t actually taken the money basically balances out to if they had not taken the loan at all.

However the idea of creating more money is that the bank now has two instances of $1000, the money in the deposit account that gave it the money to loan and the money in the account of whoever it was loaned to. Now there is $2000 “out there” in concept where before there was only $1000.

Anonymous 0 Comments

Think you’re taking about quantitative easing, which is unrelated to the bank loan process.

Anonymous 0 Comments

You are asking multiple questions. Your notion of debits and credits is the simple one – Bank loses $1000 and gains an account receivable of $1000 + interest.

Your broader question of ‘how do banks *create* money’ is the more complicated and important one. When the bank loans you $1000 you go ahead and spend it. Now the company you gave $1000 for a product has more money and they in turn spend that money. And so on and so on. That $1000 has now injected several thousand dollars into the economy in terms of consumption, and new jobs to meet that demand.

This whole time, the money supply has not changed (this is a completely different topic), but the initial loan has created economic growth.

Anonymous 0 Comments

Everybody here is misunderstanding the question. They think he’s asking “how do they profit” and that answer is “interest”. But the question is really, “How do banks create NEW DOLLARS”.

The answer is that **banks are allowed to loan more money than they have on deposit**. If they have $1 billion in assets, they can legally loan $1.2 billion in money. That “creates” $200 million in new dollars. (I’ve made up the exact numbers, but the principle remains).

There are rules and regulations which strictly control how much reserve the banks must maintain when they loan. This allows them to have more or less money enter the money supply. When they raise the reserve amount, that means fewer dollars can enter the economy. When they lower the reserve amount, more dollars can enter the economy.

There is also the *discount rate* that is the amount of interest the Fed charges for short term loans (days in length). Lowering that rates encourages more money to enter the system, raising that rate slows down money entering.

It is explained here:

[https://www.investopedia.com/ask/answers/07/central-banks.asp](https://www.investopedia.com/ask/answers/07/central-banks.asp)

**tl;dr** with strict limits, banks are allowed to loan more money than they have, that creates dollars.

Anonymous 0 Comments

Let’s say a bank has ten depositors who each have $1000 in their accounts – a total of $10,000. And let’s assume there’s a 20% reserve requirement, so the bank has to keep 2 grand in the vault in case any of the depositors wants their money.

That means the bank can now make eight $1000 loans. Total money is now $18,000: ten savings accounts worth $1K each, plus eight people who have $1K in hand.

The collective balance sheets won’t show any new money (each borrower has the asset of $1K and an offsetting liability of $1K), so the banks didn’t “make” new money. But there are now 18 people who could spend $1000, so there’s “more money in the system”.

If all 18 actually did spend the money there would be a problem – and that’s called a [run on the bank.](https://www.econlib.org/library/Enc/BankRuns.html)

Anonymous 0 Comments

>I don’t get how the loan, the absence of money, is an **asset** on the lending bank’s books

I think you actually get it. When loans (and therefore new money) are created, they **are not** by themselves an “asset” to the bank.

The key point to remember is there’s *always* two parts of a transaction. I.e., for every credit, there’s a corresponding debit somewhere.

Or a slightly different way of looking at this: for every increase in **asset**, there’s a matching increase in **liability** somewhere.

When a bank creates a loan, two events immediately happen on their books (from the bank’s perspective):

1. The *loan agreement* is created, which is an **asset** to the bank since it’s a promise from the customer to pay back the loan with interest
2. On the flip side, a *deposit* is also created on the customer’s account, which is really a **liability** on the bank (the bank must make available this amount to the customer)

**The** **moment the loan is created, the increase in the bank’s asset is immediately offset by the increase in the bank’s liability**. They effectively cancel each other out, and therefore loans by themselves are not a net asset to the bank.

In event #2 above, the deposit to the customer corresponding to the loan is how money is created by the bank. The customer now has money in their account, and that money didn’t exist before the loan.

Of course, banks expect that their loans in the long run will make them money through interest payments, fees, etc. But the loan creation itself is not a net asset to the bank.