How Do Banks Create Money?

Commercial banks are able to create money by lending it to their customers in amounts that exceed the reserve capital they keep on-hand. Unsecured loans temporarily expand the money supply by crediting borrowers’ accounts with money that does not exist in any real sense.

Banks work by accepting deposits and making loans to borrowers. In theory, the deposits act as security for the loans that are then made by the bank. Banks charge higher interest on loans than they pay in interest, which generates a profit margin that keeps them in business while managing the available money supply in a responsible way. In practice, banks almost always lend out far more money than they keep in deposits. If a depositor keeps $100,000 in a savings account, that money can be used as security for one loan of $40,000, another loan of $50,000 and a third loan of $75,000. Together, these loans add up to $165,000. In this scenario, the extra $65,000 is money that has not been issued by the government but has been created from nothing by crediting borrowers’ accounts with money that they are, in principle, obliged to pay back with interest. Commercial banks thus have the ability to unilaterally expand the money supply simply by lending money they don’t possess in a physical sense.