Do banks really create money out of thin air?

Most people tend to think of banks as intermediaries between people with savings and people who want to borrow money. They loan out deposits to borrowers, and make a profit by charging more interest than they pay savers.

But is this an accurate description of how banks work? Nowadays, there’s a lot of debate about where banks actually get the money for loans, with some suggesting deposits may not be the source after all. Below, we explore a few of the main theories.

Theory #1: Financial Intermediation Theory

The idea behind the financial intermediation theory is fairly straightforward: banks gather funds from depositors and turn them into loans for investors. It’s probably the most widely-held view of how banks operate, and certainly the easiest to get your head around.

In this model, banks don’t have the power to create money — they simply channel it from one group to another. Their main obligation, then, is to manage risk, which they do by assessing borrowers' creditworthiness before handing out loans.

But this raises a few questions. For example, if banks can only lend out pre-existing deposits, doesn’t that make lending completely dependent on customers’ savings habits? Another theory recognises these limitations and offers a different perspective.

Theory #2: Fractional Reserve Banking

The basic premise of fractional reserve banking is that most people are unlikely to withdraw all their money at once, so banks should be able to keep just enough cash in reserves for liquidity purposes while using the rest to fund loans.

Under this system, banks play an important role in actually creating much of the money supply in the economy, thanks to something called the ‘money multiplier.’

The money multiplier works like this: whenever someone deposits $1,000 with a bank, around 10% - $100 - will be held in the bank’s reserves, while the remaining $900 will be loaned out to other customers.

Let’s say a borrower uses that money to hire someone to renovate their kitchen. Once the job is done and money changes hands, the builder takes that $900 and deposits it into his personal bank account.

Whichever bank receives that money will then be inclined to keep 10% in its own reserves and loan out the other 90%, just as the previous bank did. Just like that, another $810 is now magically in circulation.

This process of credit extension continues until that initial $1,000 deposit has funded several thousand dollars worth of loans, fuelling more economic activity than would be possible if it were kept idle.

It’s a neat explanation, but it’s also come under scrutiny in recent years, with many economists claiming it’s completely at odds with current practice. How so? Let’s take a look at another theory.

Theory #3: Credit Creation Theory

In 2014, the Bank of England realised that most people held some very confused ideas about where money comes from. Hoping to put these misconceptions to rest, it released a report titled ‘Money Creation in the Modern Economy.’

The report explained that when a commercial bank issues a loan, the money isn’t drawn from existing deposits. Rather, it’s conjured into existence by the stroke of a pen (or, more accurately, by a few keystrokes on a computer).

If the loan is granted to purchase a property, this “new money” will at some point be transferred to the seller. And as soon as it’s deposited into their bank account, the total money supply increases.

Of course, any money credited to borrowers in the form of a loan must eventually be paid off. And when that happens, that very same money will be destroyed.

This system contrasts with other views of banking, where causation flows from deposits to loans. But according to the BoE report, commercial bank deposits “are a liability of the bank, not an asset that could be lent out.”

If you’re confused, that’s probably the correct response. Even the famous economist John Kenneth Galbraith once said “the process by which banks create money is so simple that the mind is repelled.”

But if deposits are a product of loans and not the other way around, this has important implications, not just for our personal finances but for public policy. Let’s consider just one example.

What are the real world implications?

In 2008, as the global financial crisis was threatening to topple economies the world over, the US government made the unpopular but arguably necessary decision to bail out the country’s banks and financial institutions.

Doing so, economists believed, would have far greater benefits for the economy than if that same money was put directly in the hands of the country’s mortgage holders.

As president Barack Obama put it at the time, “a dollar of capital in a bank can actually result in eight or ten dollars of loans to families and businesses, a multiplier effect that can ultimately lead to a faster pace of economic growth."

Unfortunately, that’s not what wound up happening. As it turned out, banks’ willingness to lend didn’t depend on how much money they held in their reserves but on how much appetite borrowers had for debt.

So what happened? Excess reserves skyrocketed but private sector lending fell. In the end, the amount of money in circulation increased by only a fraction, and the massive injection of government money failed to deliver the economic growth it promised.

The bottom line

While it might be difficult to grasp, the credit creation theory has received plenty of support over the years from researchers and major financial institutions alike. 

And since the Bank of England report was published, a number of central banks, including the Deutsche Bundesbank, Norges Bank and Swiss National Bank, have released similar resources hoping to set the record straight in their own countries. 

Granted, it might take some time for this information to take hold more widely, but the next time a friend or family member claims that money doesn’t just appear out of thin air, you can point to the closest bank and tell them otherwise.