<p><strong>Banks create real money simply by approving a loan.</strong></p>
<p>The intermediary &quot;theory&quot; is a misconception, at least regarding money creation as it works today as you point out yourself. Banks don’t lend out customers deposits. On the contrary: By approving a loan, a bank, say Bank A, creates a deposit of the same amount in the customer’s account. For all intents and purposes this deposit is already real money. In fact, this so-called broad money is used for the vast majority of transactions in a modern economy (direct debits, bank transfers, credit card purchases, etc.).</p>
<p>As a result of this money creation, the balance sheet of bank A grows. There is a claim on repayment of the loan on the asset side, and the liability side reflects the new deposit which A owes to the customer. But A’s reserves - the kind of money only the central bank creates, and which is used by commercial banks to settle accounts between them, remain unaffected by that process. Only when the customer transfers some of the money to another bank B do reserves come into play. A will transfer its liability (the deposit) to B and, to make up for it, it will also transfer reserves of the same amount (an asset). Although A has now less reserves, and B more, the total amount of reserves in the banking system has not changed, other things equal. So, banks can create real money (the money used in commercial transactions) simply by that process, and reserves don’t play a role in the process itself.</p>
<p><strong>Effects of making a loan on balance sheets</strong> (without reserve requirements)
<a href="https://i.sstatic.net/scT7h.png" rel="nofollow noreferrer"><img src="https://i.sstatic.net/scT7h.png" alt="Making a loan (without reserve ratios)" /></a>
<em>Source: BoE quarterly bulletin extract (2014)</em></p>
<p>However, if in place, <strong>reserve requirements</strong> (when banks need to hold a certain ratio of their deposits in reserves or cash), do limit the amount of money that can be created, but are not involved in the process of how money is created by commercial bank. Reserve requirements, even if they exist, have become much less relevant over time, partly because of securitization (of loans/deposits, think about lowest-quality mortgage securitization ahead of the financial crisis), which allows them to restructure their balance sheet in favor of more reserves.</p>
<p>That doesn’t mean the central bank can’t steer the creation of money or do it itself. On the contrary, monetary policy is all about balancing the relationship between inflation, money supply, and interest rates (the price of money). And of course, the central bank can affect the amount of money more directly via quantitative easing, but that was not the question.</p>
<p>Capital requirements are designed to curb systemic risk and, possibly, to limit the speed of money creation. If a bank accumulates profits into capital, it can still grow its deposits and hence create ever more money, the speed of which is only limited by the speed at which it can grow its capital.</p>
<p>What will limit the amount of money that is created are the banks’ profit considerations in the context of competition and macro-prudential regulation. You could argue that banks can, and do, create money out of “thin air” when they approve unsecured loans (credit card debt, overdrafts), because there is no collateral backing it up. But in many cases, especially for larger loan amounts, banks will require some high-quality collateral to approve a loan (for example the rights to the home for a mortgage loan).</p>
<p>As banks increase their loan portfolio, remaining loan opportunities will eventually become too risky relative to interest rates banks can charge in a competitive environment (or, in other words, borrowers as a whole run out of high-quality collateral). At that point banks will stop lending and, hence, stop creating money. Note that this risk is perceived risk, and money creation by commercial banks will ultimately depend on how they perceive risk. Macro-prudential regulation, such as caps on loans-to-value ratios impose limits to the risks banks can take from the outside, and hence limits money creation in that way.</p>
<p>If an individual person were granting a loan it would be different for a variety of reasons. Most importantly, unlike banks, you don't have access to reserve money and cannot borrow reserves from other banks or the central bank when people actually want to see their money right away, which will always be the case in that situation. So, you wouldn't be able to create money.</p>
<p><strong>References</strong> (all focusing on the UK, but most mechanisms are general):</p>
<ul>
<li><a href="https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/2014/money-creation-in-the-modern-economy.pdf" rel="nofollow noreferrer">BoE quarterly bulletin extract (2014)</a></li>
<li><a href="https://www.bankofengland.co.uk/quarterly-bulletin/2014/q1/money-creation-in-the-modern-economy" rel="nofollow noreferrer">Money creation in the modern economy, BoE, quarterly bulletin (2014)</a></li>
<li><a href="https://www.goodreads.com/book/show/13144133-where-does-money-come-from" rel="nofollow noreferrer">Where does money come from</a></li>
</ul>

CC BY-SA 4.0
2021-07-16T18:28:52.897Z
+1, this answer is more detailed, however: "What will limit the amount of money that is created are the banks’ profit considerations in the context of competition and macro-prudential regulation:". This is just fancy way of saying private banks **can** only create money from their reserves/capital buffer and *will be* created if bank finds creating them profitable (which is separate question from how they are created) . Sure profit  is one of the ways capital or reserves can be accumulated (as you mention in one other para) but without them private bank cannot create more money  money.
1muflon1
CC BY-SA 4.0
2021-07-16T18:36:16.247Z
In addition the first bold sentence is wrong according to your own answer, even though the rest of the explanation is sound, since as you explain in your answer banks cannot create money out of thin air, they can only do that within the constraints imposed by central bank from capital/reserves
1muflon1
CC BY-SA 4.0
2021-07-16T18:40:08.020Z
-1 by me the first sentence is blatantly false, I don't care how well rest is written. You should read Rendahl & Freund https://voxeu.org/article/banks-do-not-create-money-out-thin-air
csilvia
CC BY-SA 4.0
2021-07-16T18:48:21.423Z
@csilvia: Just because someone else says the opposite doesn't make it false. What's wrong with my reasoning? Btw, I admit that "out of thin air" is not scientific, open to interpretation, and may have a provocative touch.
BrsG
CC BY-SA 4.0
2021-07-16T18:52:02.143Z
@1muflon1: Appreciate it. There is a difference, though. Answering the question how are banks creating money (referring to the process) is different vs how much can they create and at which speed? How is unaffected by reserve amounts or capital requirements, whereas they matter for the maximum amount and speed.
BrsG
CC BY-SA 4.0
2021-07-16T18:57:21.097Z
@BrsG the problem is that it is wrong. Also, it is not about someone else saying something. In literature, creating money out of nothing is understood as being able to expand money supply without any constraint like central bank that can *actually* create money out of nothing. Commercial banks create private money by transforming an illiquid assets into a liquid ones, that is not out of thin air. Claim that private banks create money out of thin air also leads to whole plethora of garbage monetary theories so it is important claim. if you rephrase that sentence I can change my -1 to +1.
csilvia
CC BY-SA 4.0
2021-07-16T19:23:21.623Z
@BrsG no how is affected by this since it suggests that private bank can only produce money from high powered money. Saying its created out of nothing is incorrect, if it is created using some other instrument. Take an analogy, if firm producing totems can manufacture 10 totems out of piece of wood, the totems are not created out of nothing just because in one time period firm only uses 50\% of its wood inventory and creates only 5 totems and then uses rest of that inventory in next accounting period. The same holds for capital/reserves. Banks can only create money from high powered money
1muflon1
CC BY-SA 4.0
2021-07-16T19:25:28.680Z
(e.g. capital/reserves) just because in one time period they have excess capital  that does not mean that up until they get to the limit they are not creating money from that capital. That just means they did not exhausted their 'inventory' of high powered money. Or are you seriously want to suggest that banks can create as much money as they please without having any high powered money (like capital or reserves)?
1muflon1
CC BY-SA 4.0
2021-07-16T21:10:46.060Z
@BrsG Thanks for your answer.  To pick up on a small part of it - does it follow that it makes a difference to a loaning bank whether the recipient of the loan withdraws that loan in cash, or tries to transfer it digitally to another bank (which needs settlement with central bank reserves)? Or do banks get cash by ‘buying’ it with their central bank reserves balance?
JCW
CC BY-SA 4.0
2021-07-19T08:42:58.350Z
@JCW: yes, for physical withdrawals, banks simply convert some of their reserves at the central bank into currency and have it delivered to them. Of course, they usually keep a certain amount on site, only only exchange net amounts with the central bank.
BrsG
CC BY-SA 4.0
2021-07-19T09:23:00.123Z
Edited my post: (1) Changed header, because the interpretation of "out of thin air" is contentious; (2) added two bits on collateral (this was previously only implicit in risk and profit considerations; (3) added image.
BrsG
CC BY-SA 4.0
2021-07-19T09:23:59.710Z
@csilvia: edited my post to *explicitly* encompass https://voxeu.org/article/banks-do-not-create-money-out-thin-air.
BrsG
CC BY-SA 4.0
2021-07-19T09:39:15.567Z
@1muflon1: Money creation works just fine without reserve requirements, provided other regulation is in place. that's why there is a trend of getting rid of reserve requirements. Also, reserve requirements, even if they exists, do not have much of an impact on money creation anymore, for example because some of the limitations can be "securitized away". The central bank will also normally provide, via OMOs for example, whatever reserves are required in the banking system as a whole, given its policy rate.
BrsG
CC BY-SA 4.0
2021-07-19T09:42:05.913Z
@BrsG 1. well yes but capital requirements/capital buffers are just reserve requirements with different name. So this is moot point. On a conceptual level there is no difference between regulation that states you have to have 10% reserves for every loan you give out, or you have to have 10% *capital* set aside for every loan you give out. 2. Also nobody is saying money in principle could not be created out of thin air, but under current capital requirements regulation *private* banks are **not allowed to create money out of thin air.**
1muflon1
CC BY-SA 4.0
2021-07-19T09:45:02.343Z
@1muflon1: Capital requirements are different because they apply to categories of riskiness, ie the risky part of the loan, so there is not much of a limitation for low-risk loans. In the sense that it focuses on risk, capital requirements are smarter. And you get much more loans for the same 10%. Ultimately, limits can obviously bind.
BrsG
CC BY-SA 4.0
2021-07-19T09:47:43.877Z
@BrsG no I completely agree on this point, but again think about it on conceptual level. We could just make different reserve requirements per different categories of risk and it is literally the same as these capital requirements. And I 100% agree that capital requirements are smarter, better and completely support the shift from reserve requirements to capital requirements. But lets not pretend that capital requirements some exotic new policy. They are just reserve requirements applied in a smarter way on fundamental level
1muflon1
CC BY-SA 4.0
2021-07-19T09:49:50.377Z
@1muflon1: Absolutely.
BrsG
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2021-07-16T16:37:05.320Z
2021-09-26T00:44:30.213Z
2021-09-26T00:44:30.213Z
BrsG
<blockquote>
<p>where does it actually come from?</p>
</blockquote>
<p>The money comes from the reserves (note not in 1:1 ratio necessarily - the ratio of reserves to money is typically very small actually) provided by central bank (or possibly from other private bank that happens to have excess reserves/capital), and the reserves themselves are created out of nothing by government decree by central bank (hence why it is called fiat money). If a bank lends out money,  and the lending is not made from deposit, then it has to ask central bank for enough reserves to maintain its reserve requirements (or in present day capital requirements since reserve requirements were abolished but capital requirements work in analogous way).</p>
<p>You can have look at  <a href="https://www.bankofengland.co.uk/quarterly-bulletin/2014/q1/money-creation-in-the-modern-economy" rel="nofollow noreferrer">McLeay et al 2014</a> for more detail (although the paper is bit out of date nowadays due to abolishment of capital requirements and in some places uses bit non-standard terminology).</p>
<blockquote>
<p>Is the money being lent out 'real'?</p>
</blockquote>
<p>Of course it is. You can use the money for everything you can use coins or notes in circulation for. In addition, ultimately all fiat money comes from government whether it be central bank (or in some countries like US, both central bank and federal government since mint and bureau of printing is technically part of US treasury).</p>
<blockquote>
<p>Is the act of a bank granting a loan intrinsically different from, say, you or I doing so?</p>
</blockquote>
<p>In what way? Banks can endogenously increase money supply by asking central bank for additional reserves, if they face high demand. An individual cannot do that. Obviously, there is also more complexity in bank loan than in individual loan because of all the institutional context.</p>

CC BY-SA 4.0
2021-07-15T17:33:11.697Z
Thanks for your reply.  Clearly, once the money has left the auspices of the bank, it is indistinguishable from money acquired any other way.  But before that, at the moment of the loan’s approval, doesn’t the bank effectively give itself permission to let more of its limited supply of ‘hard cash’ out into the world, by recording on its balance sheet that it has traded some of its cash for a future income stream of greater value?  Are you saying that it can keep going, issuing more ‘hard cash’ than it ever possessed, by drawing on central bank reserves?
JCW
CC BY-SA 4.0
2021-07-15T19:23:08.357Z
@JCW most money is digital not in cash, if banks gives out loan it does not actually hand you bag with a \$ sign on it full of bills, it sends it to your account. Also, supply of physical cash is not really limited, banks can order more of that stuff it there is insufficient of it to circulate (here is an explainer on how the cash works https://www.newyorkfed.org/aboutthefed/fedpoint/fed01.html). If more cash is needed more can be always printed out, but nowadays people typically just keep money electronically most loans are never even cashed in the literal sense of that word.
1muflon1
CC BY-SA 4.0
2021-07-16T10:26:49.157Z
Your first paragraph gives the impression that the amount of reserves required to make the loan is equal to the amount of the loan itself. This is generally not true. Indeed in general the amount of reserves needed to make a loan is a tiny fraction of the size of the loan.
Mick
CC BY-SA 4.0
2021-07-16T10:29:30.377Z
@Mick I never stated that they are equal, you are right that amount of reserves is only small fraction, but they are needed and generally banks don’t have reserves just laying around so if they face extra loan they need extra reserves
1muflon1
CC BY-SA 4.0
2021-07-16T10:32:06.547Z
By saying "The money comes from the reserves" you give that impression. A truer answer would be more like: "3% comes from reserves 97% is created out of nothing".
Mick
CC BY-SA 4.0
2021-07-16T10:34:07.800Z
@Mick no what you say is completely incorrect if you would actually read literature, if we want to go into detail correct way would be stating \$1000 come from \$10 (or whatever reserves are required) not from nothing since the 97% (or whatever the true share is) cannot exists on its own without the 3% and is derived from it. So yes money literally comes from reserves not in 1:1 ratio, but I never claimed it did
1muflon1
CC BY-SA 4.0
2021-07-16T10:37:54.583Z
I was just quoting Adair Turner... even truer would be 3% from reserves, 97% is created from converting the borrower's non-spendable IOU (the borrower's promise to pay the principal back to the bank) into a spendable IOU (the demand deposits).
Mick
CC BY-SA 4.0
2021-07-16T10:37:58.310Z
@Mick anyway I updated the caveat about 1:1 ratio in my answer, but still all loan comes from reserves
1muflon1
CC BY-SA 4.0
2021-07-16T10:41:56.520Z
@Mick but it still comes from reserves. Let me give you analogy if firm has production function Y=10L so 1 unit of labor gives you 10 unit of output, did 9 units of output came out of nowhere and 1 from labor? No all of them came from labor. Reserve is necessary input for any loan. The loan value does not come out of nothing it comes from the reserves. Central bank reserves come out of nothing not private loans. The quote just describes a process how reserves can be turned into more money, that more money still originated with the reserves
1muflon1
CC BY-SA 4.0
2021-07-16T10:47:39.053Z
@Mick for example no matter what’s the borrowers future streams of cash flows are if banks has no excess reserve, and central bank is not playing ball and refuses to create new reserves, no new money can be created, loan cannot be given out otherwise bank would violate capital requirements regulations. Only if the bank has sufficient capital/reserves new loan can be extended. Of course not necessarily in 1:1 ratio, but reserves are necessarily
1muflon1
CC BY-SA 4.0
2021-07-16T10:49:16.080Z
Both reserves and the borrower's promise to repay, are necessary ingredients in the loan so to ascribe the source of the loan to just one of the ingredients is misleading.
Mick
CC BY-SA 4.0
2021-07-16T10:54:40.290Z
@Mick sure for loan to exist there must be demand for loan, but the money for that loan come from high powered money not from nothing that’s the point
1muflon1
CC BY-SA 4.0
2021-07-16T11:00:43.037Z
The words: "(note not in 1:1 ratio necessarily)" gives the impression that it's at least in the same ballpark as 1:1 which is false.
Mick
CC BY-SA 4.0
2021-07-16T11:01:50.533Z
@Mick how does it give that impression? Now you are stretching it anyway I will edit my answer to also clarify that the ratio of reserves and money is typically small
1muflon1
CC BY-SA 4.0
2021-07-16T11:08:49.353Z
@1muflon1 But in practice, the decision to grant the loan is made independently of the subsequent inter-bank settlement in net flow of central bank reserves between banks, so I don’t see how your claim about the ‘source’ of the loan can be true.
JCW
CC BY-SA 4.0
2021-07-16T11:28:17.880Z
"generally banks don’t have reserves just laying around" may have been true before 2008 but the position may have changed: see https://fred.stlouisfed.org/series/TOTRESNS
Henry
CC BY-SA 4.0
2021-07-16T11:31:22.543Z
@JCW no it is not independent. Post 2008 central banks decided to pursue policy of providing as much liquidity (reserves) as private banks want. But that is literally central bank policy, if central bank would tomorrow decide, sorry guys no more reserves, then private banks cannot issue more money than what they can with their current level of reserves they would literally violate the law. Also just because in practice timing is different that does not mean the statement is not true in practice often  final manufacturer makes sale before even having materials. That does not mean you can produc
1muflon1
CC BY-SA 4.0
2021-07-16T11:31:39.407Z
Produce stuff out of nothing
1muflon1
CC BY-SA 4.0
2021-07-16T11:34:09.990Z
The sentence "Banks can endogenously increase money supply by asking central bank for additional reserves, if they face high demand." is misleading. It gives the impression that the increase in the money supply is one and the same thing as the increase in reserves. Not true.
Mick
CC BY-SA 4.0
2021-07-16T11:34:12.070Z
@1muflon1 Ok, to be concrete: I’m British and most familiar with the UK economy. Can you identify a concrete statement of the capital requirement regulations that apply for the UK banking system?
JCW
CC BY-SA 4.0
2021-07-16T11:36:35.090Z
@Henry that’s total for the whole banking system there is still a lot of heterogeneity on bank level many individual banks will still work with very little to none excess reserves but otherwise your point is correct that prior 2008 there were virtually no excess reserves, but even now many depository institutions try to keep as little excess reserves as possible it’s simply bad for their profitability, also some of that was because capital requirements were in some cases higher than reserve requirements now that banks have no reserve requirements the extra capital above cap req is not as large
1muflon1
CC BY-SA 4.0
2021-07-16T11:40:34.673Z
@jcw the capital requirements in the UK differ by bank type and also by their balance sheet structure, you can read about that here https://www.bankofengland.co.uk/statistics/details/further-details-about-banking-sector-regulatory-capital-data
1muflon1
CC BY-SA 4.0
2021-07-16T11:50:11.673Z
@Mick what are you talking about? 1. Reserves are literally part of money supply. 2. If broad money supply increases endogenously reserves have to be increased to maintain the reserve requirement. This literally holds in endogenous money supply model so how is that misleading?
1muflon1
CC BY-SA 4.0
2021-07-16T11:54:45.150Z
Slightly depending on exactly which definition of the money supply you choose... a 100 dollar loan may increase the money supply by about 100 dollars but only necessitate an increase in total reserves of less than 5 dollars
Mick
CC BY-SA 4.0
2021-07-16T11:58:09.867Z
@Mick but again I am never stating that the money supply increases 1:1 and already I literally stated at the start of my answer that the ratio to reserves and money is not 1:1 I am talking only about increases dM>0 requires dR>0, at this point it looks like you are not arguing in good fait but just for arguing sake, in the first reply I guess I can kinda see how someone could think without clarification that R:M=1 but since that was already cleared in the first paragraph you are just repeating yourself, the answer already clearly explains ratio of R:M is not 1
1muflon1
CC BY-SA 4.0
2021-07-15T12:53:11.880Z
2021-07-16T11:02:23.037Z
2021-07-16T11:02:23.037Z
1muflon1
<p>Each bank has a Chart of Accounts including accounts that are designated Assets, accounts that are designated Liabilities, and the difference between Assets and Liabilities is Owner's Equity or just Equity.</p>
<p>This four page pdf paper shows a simplified balance sheet and income statement for a fictional bank:</p>
<p><a href="https://www.richmondfed.org/%7E/media/richmondfedorg/publications/research/economic_brief/2012/pdf/eb_12-03.pdf" rel="nofollow noreferrer">https://www.richmondfed.org/~/media/richmondfedorg/publications/research/economic_brief/2012/pdf/eb_12-03.pdf</a></p>
<p>where Assets equal Liabilities plus Equity in the balance sheet. The reserves for loan loss account (also known as the loan loss reserve or LLR) is considered to be a contra-asset account. If one makes this account equal to zero then the assets would increase by that amount and the Owner's equity would increase by the amount in the LLR. So the loan loss reserve is a way to anticipate an expense charge against equity claims in the event that there is a default loss in the loan portfolio. Therefore equity claims on banks are reduced when loan defaults occur. Deposit levels are not directly coupled to loans or defaulted loans due to the equity market which drains deposits to create equity claims on the Liabilities and Equity side of the bank and aggregate Bank sector balance sheet.</p>
<p>This ten page pdf paper describes how banks create money and then also borrow money to keep interbank payments flowing in the reserve payment system:</p>
<p><a href="https://think.ing.com/uploads/reports/Money_paradox2.pdf" rel="nofollow noreferrer">https://think.ing.com/uploads/reports/Money_paradox2.pdf</a></p>
<p>Assuming the government does not print and spend physical currency to cover its deficit spending then new money must be created primarily via legal and accounting customs in the aggregate bank sector. When each bank issues a new loan it increases Loan Assets and increases Deposit Liabilities. This is stated as &quot;Loans create deposits.&quot; However any time a bank loans money or makes a credit entry to the deposit account of a non-bank counter-party this is the creation of bank deposit money via accounting and legal customs. When a non-bank pays a bank via the decrease of deposit money in their account this is destruction of deposit money via legal and accounting customs.</p>
<p>The Cash account(s) for a bank consist of vault cash (notes and coin for servicing withdrawals) and of reserve balances at the central bank. Banks use Reserve Balance Assets to make interbank payments. The central bank must provide all the Reserve Assets necessary to service the currency drain and to clear interbank payments via daylight credit. If the central bank wants to limit the credit issued by banks it can attempt to restrict the amount of Reserves in the aggregate bank sector and impose regulations on the bank sector if operating as the primary regulator. However in a systemic crisis or banking panic the failure to provide all the Reserves necessary to operate the payment system and service the currency drain would have adverse consequences for the credit system as a whole and for the transactions in the real economy.</p>
<p>When the federal government deficit spends in the United States it sells Treasury securities to cover the difference between spending and taxes. The so-called &quot;National Debt&quot; is mostly issued as the float of Treasuries which must roll-over and grow if the government continues to spend more than it taxes on average over the history of the nation. However these Treasuries are considered to be risk-free assets of their owners and in the economic sense of term they are &quot;economic substitutes&quot; for government insured bank deposits. When a student borrower in the United States defaults on an direct federal loan or government guaranteed student loan the Federal government would either have to collect taxes or fees to offset this loss or allow the Treasuries float to increase while making a decrease of the government net worth if the government writes off the loan.</p>
<p>Suppose loans default in the private sector. The bank must write down its equity when the loan defaults and it writes off the asset. So the banking system allocates the &quot;sins&quot; of financial default to the reduced rate of increase of equity. Since bank equity drains deposits via the equity markets the write-off of defaulted loans against equity means deposits do not persist in perpetuity when corresponding loans default. However in a systemic banking crisis the government is forced to bailout the bad debts in the bank sector and to insure more deposits to keep the payment system operating and to ensure that the real economy is not cast into another Great Depression caused by systemic defaults and financial panic. So in a systemic crisis the loan defaults will not consume the equity of the bank sector if the government institutes policies to recapitalize the aggregate bank. Then one might argue or recognize that deposits persist as deposits rather than converting into equity or uninsured deposits which would absorb the write-off of bad loans in the aggregate loan portfolio.</p>
<p>A rational policy for a modern nation that does not want to bailout bad debts would be to force the super-wealthy to write off their financial net worth rather than increase the Sovereign debt. This would be a modern Jubilee where in ancient times the King would force the wealthy to write off bad debts to reset the economy. However the modern financial system makes it almost impossible to force those with vast wealth to take a write-off through the financial sectors. This is a political problem in the legislature caused by the complexity of industrial credit systems and financial intermediaries.</p>

CC BY-SA 4.0
2021-07-17T21:10:04.823Z
+1 really interesting point about equity absorbing loan defaults resulting in a net-zero effect on total deposits.  I don't really understand what you're proposing in the last paragraph though.  Are you saying make jeff bezos buy the bad mortage backed securities in 2008?
Mr. Cooperman
CC BY-SA 4.0
2021-07-17T21:23:58.157Z
Financial intermediaries (banks or non-banks) hold a portfolio of financial assets while issuing a mix of insured debt, uninsured debt, and equity. If there is a large unexpected default in the asset portfolio the insured investors get to keep their investment funds; the equity investors take the first loss; and the uninsured debt investors take the next loss. Demographically the super-wealthy have positive net worth independent of the valuation of real estate and leverage caused by the financial intermediaries issuing debt against collateral. So only those investors could take the write-off.
SystemTheory
CC BY-SA 4.0
2021-07-17T02:41:16.323Z
2021-07-17T04:49:27.610Z
2021-07-17T04:49:27.610Z
SystemTheory
<p>The money is &quot;&quot;&quot;real&quot;&quot;&quot; in the sense that it's <em>backed</em> by &quot;real money&quot; even though it's <em>not</em> &quot;real money&quot;.</p>
<p>Think about this: You go into a bank and ask for a \$1,000 loan. They say yes. They update their database - now their loans are \$1,000 more and your balance is \$1,000 more. So far, no &quot;real money&quot; has been involved.</p>
<p>But then, you go to the teller and you say &quot;I'd like to withdraw \$1,000 please.&quot; <em>Now</em> they have to give you $1,000 of cash. And they aren't allowed to print that cash - that cash is &quot;real money&quot; to them.</p>
<p>Maybe you don't want cash. Maybe you want to buy a cheap car, so you use your card, and now your balance is \$1,000 less and the car seller's balance is \$1,000 more. And now the car seller may go to the teller and ask for \$1,000 of real money.</p>
<p>The fact that your bank balance may be converted to real money at any time is what gives it a real money value.</p>
<p>In any case, after the withdrawal happens, the bank is now down \$1,000 of real money, even though they have the same total balances in accounts, and \$1,000 more of loans. The bank has to keep a close watch on the account balances people have, versus the amount of real money they have. If their account balances are too high compared to their real money, they can't make more loans.</p>
<p>If they do make more loans anyway, it puts them at risk of bankruptcy, and they don't want to do that because bankruptcy makes their shareholders lose money.</p>

CC BY-SA 4.0
2021-07-15T17:22:43.297Z
Thanks for your reply.  I understand this presentation of the concepts.  But I still don’t quite see how it can work like this in practice.

We know that banks don’t actually have enough assets to convert their entire balance sheet simultaneously to ‘real’ cash, so your ‘The fact that…’ line seems wrong?

And we also know that some non-negligible amount of debt is never repaid.  That is, the bank would on average release more ‘real money’ into the economy than it gets back - *except* that it also collects interest payments. Does the bank therefore rely on total interest exceeding defaults?
JCW
CC BY-SA 4.0
2021-07-16T09:26:38.393Z
@JCW Well, yes? Of course they rely on interest exceeding defaults. Otherwise they'd gain nothing from the loans.
Criticize SE actions means ban
CC BY-SA 4.0
2021-07-16T09:27:44.560Z
@JCW And yes, there are strict regulations on banks to make it so they're extremely unlikely to run out of real money, and there are other regulations to make it so in the unlikely even they *do* run out of real money, the government can print some for them (but they have to pay it back later!). Before these regulations were put in place, a bank collapsed and all its customers lost their savings *every week*.
Criticize SE actions means ban
CC BY-SA 4.0
2021-07-16T11:11:40.827Z
Of course they expect interest to exceed defaults at the point of granting the loan, but given what we know of the economic cycle, it is almost certain that there will be periods in the lifetime of a typical mortgage (say) when aggregate defaults will exceed aggregate interest.  Is this why banks reduce lending during financial downturns?
JCW
CC BY-SA 4.0
2021-07-16T11:15:08.687Z
@JCW Sure, and also why they build up savings when things are good, same as any business that doesn't want to go bankrupt. I think that part can just be analyzed as business profits/losses.
Criticize SE actions means ban
CC BY-SA 4.0
2021-07-16T11:22:25.573Z
@JCW in effect the money has come from the bank's willingness to create an asset and a liability when lending to you.  This comes with a risk, and the bank's willingness to take risks affects how much they are prepared to do this.  In 2008 the banks found they were in a much riskier position than previously thought and cut back on lending.  In 2020 that did not happen, and the banks remained willing to make loans, though many potential borrowers were themselves unwilling to take risks of new loans during lockdown.
Henry
CC BY-SA 4.0
2021-07-16T11:29:30.773Z
@Henry OK, but there are two factors affecting the volume of loans a bank might be asked to make: the eligibility criteria (typically based on credit rating etc) and the proportion of people meeting those eligibility criteria who choose to seek a loan (largely based on the macroeconomic context).  Strictly it also depends on the relative favourability of different banks’ offered terms.  None of these factors is directly connected to what the bank actually needs to fulfil the loan (sufficient central bank reserves for interbank clearance)! How can this be?
JCW
CC BY-SA 4.0
2021-07-16T11:31:40.030Z
For instance, if from tomorrow all loan applications nationwide that would meet Bank A’s loan criteria went to Bank A, perhaps from a successful marketing campaign or generous terms - Bank A might be perfectly happy with the level of credit risk of all the assets it’s creating, but it still doesn’t necessarily have the resources to grant all those loans together itself (or does it?)
JCW
CC BY-SA 4.0
2021-07-16T17:05:43.577Z
@JCW risks accumulate, and (as seen in 2008) some risks can become correlated, so if there is a limit to how much risk a bank can take both for internal policy and due to external regulation, so there is a limit to how many loans a bank is prepared to make at any one time
Henry
CC BY-SA 4.0
2021-07-17T00:53:13.773Z
@JCW The bank has to estimate how many deposits people are likely to want to withdraw all at once, apply a safety factor, and then not make more loans than that. If the bank doesn't check for each loan, they've probably discovered that they don't make enough loans in one day to justify the effort of checking each loan individually. If they go slightly over their limit, it may be fine as long as they can borrow some reserves from another bank in exchange for non-reserves.
Criticize SE actions means ban
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2021-07-15T15:13:28.457Z
2021-07-15T15:13:28.457Z
Criticize SE actions means ban
<p>In the naïve picture of the banking system, banks strike a balance between savings invested in them by savers and the loans requested of them by borrowers. The money loaned to borrowers is the <em>same</em> money invested as savings, and some of the interest paid by the borrowers is passed onto the savers. In this model the bank is effectively a middleman.</p>
<p>In the real economy this isn't what happens. Because money is no longer tied to physical currency, there is no longer necessarily a direct link between money saved and money loaned.</p>
<p>And if the money for the loan, which once granted is indistinguishable from any other money, just comes from a corresponding negative entry in a bank's balance sheet: where does it actually come from? Is the money being lent out 'real'? Is the act of a bank granting a loan intrinsically different from, say, you or I doing so?</p>

CC BY-SA 4.0
2021-07-16T00:28:48.027Z
watch this: https://www.youtube.com/watch?v=KvpbQlQwl0A
Mr. Cooperman
CC BY-SA 4.0
2021-07-16T11:37:13.863Z
@Timkinsella Thanks for this - it and the other videos in the series are the closest I’ve got so far to an answer.  It’s still not clear to me what happens with loans defaulting, though: if less money is destroyed (through repayment of loans) than created (through approval of loans), doesn’t that imply the rate of increase of money supply is related to the rate of default?
JCW
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2021-07-16T11:43:03.547Z
You might like this too youtube.com/watch?v=CI5CFQXJxcA
Mick
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2021-07-16T19:53:52.770Z
@JCW Yes.  When a loan is made, money is created. When a loan is repayed, money is destroyed.  Every default means the money that was initially created by the loan will remain in the economy indefinitely.
Mr. Cooperman
CC BY-SA 4.0
2021-07-16T21:08:18.207Z
@Timkinsella Has anyone explored the macroeconomic implications of this?  It seems like a big deal, and I’ve never seen it mentioned before, let alone explored.  It certainly isn’t common knowledge.  It presumably implies that in the long run, money created by defaults will come to dominate?  Does this imply that granting riskier loans and accepting a higher incidence of defaults generates economic growth?
JCW
CC BY-SA 4.0
2021-07-16T21:29:07.887Z
More money doesn't imply more growth.  Too much money in the system can be a bad thing, and if someone defaults that usually means their project wasn't productive, which is bad for the economy.  But I agree it is shocking for a lot of reasons. Not least because of the moral attitudes about repaying debts that are beaten into us from a young age.  When people talk about the size of the national debt or the size of outstanding student loan debt they talk about it like it's a scandal.  And maybe in some sense it is, but if everyone repaid their debts tomorrow society would probably collapse.
Mr. Cooperman
CC BY-SA 4.0
2021-07-17T18:30:03.200Z
As discussed in my answer the federal government in the United States issues risk free Treasury securities which are economic substitutes for federally insured bank deposits in the financial asset portfolios. The government can write-off defaulted direct or guaranteed student loans held as financial assets if it chooses to do so and would not reduce the Treasury float unless Congress authorizes fees or taxes to offset the bad debt write-off.  The government could just reduce its net worth when it gives the write-off and society would not collapse because markets demand risk free investments.
SystemTheory
CC BY-SA 4.0
2021-07-17T18:34:56.483Z
Also discussed in my answer the write-off of bad loans on the asset side of a bank or banking sector balance sheet is accompanied by an expense charge that increases the contra-asset called loan loss reserve (LLR). If banks do not account for the LLR then they would show more Owner's equity. Owner's equity is an alternative to deposits on the bank balance sheet and exists to take the first loss on the write-off of bad debt. So a loan that defaults is not coupled to the deposit created, but rather, the deposits created migrate to equity to take the write-off of bad loans or to take the profits.
SystemTheory
CC BY-SA 4.0
2022-01-20T18:40:49.307Z
Does this answer your question? [Is money mostly created (out of nothing) by banks making loans?](https://economics.stackexchange.com/questions/26991/is-money-mostly-created-out-of-nothing-by-banks-making-loans)
James Wattam
<money-supply><banking><money><debt>
A bank approves a loan: where does the money come from?
JCW
# A bank approves a loan: where does the money come from?

(Asked by: username_0 on 2021-07-15)

In the naïve picture of the banking system, banks strike a balance between savings invested in them by savers and the loans requested of them by borrowers. The money loaned to borrowers is the *same* money invested as savings, and some of the interest paid by the borrowers is passed onto the savers. In this model the bank is effectively a middleman.

In the real economy this isn't what happens. Because money is no longer tied to physical currency, there is no longer necessarily a direct link between money saved and money loaned.

And if the money for the loan, which once granted is indistinguishable from any other money, just comes from a corresponding negative entry in a bank's balance sheet: where does it actually come from? Is the money being lent out 'real'? Is the act of a bank granting a loan intrinsically different from, say, you or I doing so?

**Tags:** money-supply, banking, money, debt
> **Comments:**
> **username_1**: watch this: https://www.youtube.com/watch?v=KvpbQlQwl0A  
> **username_0**: @Timkinsella Thanks for this - it and the other videos in the series are the closest I’ve got so far to an answer.  It’s still not clear to me what happens with loans defaulting, though: if less money is destroyed (through repayment of loans) than created (through approval of loans), doesn’t that imply the rate of increase of money supply is related to the rate of default?  
> **username_2**: You might like this too youtube.com/watch?v=CI5CFQXJxcA  
> **username_1**: @JCW Yes.  When a loan is made, money is created. When a loan is repayed, money is destroyed.  Every default means the money that was initially created by the loan will remain in the economy indefinitely.  
> **username_0**: @Timkinsella Has anyone explored the macroeconomic implications of this?  It seems like a big deal, and I’ve never seen it mentioned before, let alone explored.  It certainly isn’t common knowledge.  It presumably implies that in the long run, money created by defaults will come to dominate?  Does this imply that granting riskier loans and accepting a higher incidence of defaults generates economic growth?  
> **username_1**: More money doesn't imply more growth.  Too much money in the system can be a bad thing, and if someone defaults that usually means their project wasn't productive, which is bad for the economy.  But I agree it is shocking for a lot of reasons. Not least because of the moral attitudes about repaying debts that are beaten into us from a young age.  When people talk about the size of the national debt or the size of outstanding student loan debt they talk about it like it's a scandal.  And maybe in some sense it is, but if everyone repaid their debts tomorrow society would probably collapse.  
> **username_3**: As discussed in my answer the federal government in the United States issues risk free Treasury securities which are economic substitutes for federally insured bank deposits in the financial asset portfolios. The government can write-off defaulted direct or guaranteed student loans held as financial assets if it chooses to do so and would not reduce the Treasury float unless Congress authorizes fees or taxes to offset the bad debt write-off.  The government could just reduce its net worth when it gives the write-off and society would not collapse because markets demand risk free investments.  
> **username_3**: Also discussed in my answer the write-off of bad loans on the asset side of a bank or banking sector balance sheet is accompanied by an expense charge that increases the contra-asset called loan loss reserve (LLR). If banks do not account for the LLR then they would show more Owner's equity. Owner's equity is an alternative to deposits on the bank balance sheet and exists to take the first loss on the write-off of bad debt. So a loan that defaults is not coupled to the deposit created, but rather, the deposits created migrate to equity to take the write-off of bad loans or to take the profits.  
> **username_4**: Does this answer your question? [Is money mostly created (out of nothing) by banks making loans?](https://economics.stackexchange.com/questions/26991/is-money-mostly-created-out-of-nothing-by-banks-making-loans)  

---

## 4 answers

### Answer by username_5 on 2021-07-16. Score: 4

**Banks create real money simply by approving a loan.**

The intermediary "theory" is a misconception, at least regarding money creation as it works today as you point out yourself. Banks don’t lend out customers deposits. On the contrary: By approving a loan, a bank, say Bank A, creates a deposit of the same amount in the customer’s account. For all intents and purposes this deposit is already real money. In fact, this so-called broad money is used for the vast majority of transactions in a modern economy (direct debits, bank transfers, credit card purchases, etc.).

As a result of this money creation, the balance sheet of bank A grows. There is a claim on repayment of the loan on the asset side, and the liability side reflects the new deposit which A owes to the customer. But A’s reserves - the kind of money only the central bank creates, and which is used by commercial banks to settle accounts between them, remain unaffected by that process. Only when the customer transfers some of the money to another bank B do reserves come into play. A will transfer its liability (the deposit) to B and, to make up for it, it will also transfer reserves of the same amount (an asset). Although A has now less reserves, and B more, the total amount of reserves in the banking system has not changed, other things equal. So, banks can create real money (the money used in commercial transactions) simply by that process, and reserves don’t play a role in the process itself.

**Effects of making a loan on balance sheets** (without reserve requirements)
[![Making a loan (without reserve ratios)](https://i.sstatic.net/scT7h.png)](https://i.sstatic.net/scT7h.png)
*Source: BoE quarterly bulletin extract (2014)*

However, if in place, **reserve requirements** (when banks need to hold a certain ratio of their deposits in reserves or cash), do limit the amount of money that can be created, but are not involved in the process of how money is created by commercial bank. Reserve requirements, even if they exist, have become much less relevant over time, partly because of securitization (of loans/deposits, think about lowest-quality mortgage securitization ahead of the financial crisis), which allows them to restructure their balance sheet in favor of more reserves.

That doesn’t mean the central bank can’t steer the creation of money or do it itself. On the contrary, monetary policy is all about balancing the relationship between inflation, money supply, and interest rates (the price of money). And of course, the central bank can affect the amount of money more directly via quantitative easing, but that was not the question.

Capital requirements are designed to curb systemic risk and, possibly, to limit the speed of money creation. If a bank accumulates profits into capital, it can still grow its deposits and hence create ever more money, the speed of which is only limited by the speed at which it can grow its capital.

What will limit the amount of money that is created are the banks’ profit considerations in the context of competition and macro-prudential regulation. You could argue that banks can, and do, create money out of “thin air” when they approve unsecured loans (credit card debt, overdrafts), because there is no collateral backing it up. But in many cases, especially for larger loan amounts, banks will require some high-quality collateral to approve a loan (for example the rights to the home for a mortgage loan).

As banks increase their loan portfolio, remaining loan opportunities will eventually become too risky relative to interest rates banks can charge in a competitive environment (or, in other words, borrowers as a whole run out of high-quality collateral). At that point banks will stop lending and, hence, stop creating money. Note that this risk is perceived risk, and money creation by commercial banks will ultimately depend on how they perceive risk. Macro-prudential regulation, such as caps on loans-to-value ratios impose limits to the risks banks can take from the outside, and hence limits money creation in that way.

If an individual person were granting a loan it would be different for a variety of reasons. Most importantly, unlike banks, you don't have access to reserve money and cannot borrow reserves from other banks or the central bank when people actually want to see their money right away, which will always be the case in that situation. So, you wouldn't be able to create money.

**References** (all focusing on the UK, but most mechanisms are general):

* [BoE quarterly bulletin extract (2014)](https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/2014/money-creation-in-the-modern-economy.pdf)
* [Money creation in the modern economy, BoE, quarterly bulletin (2014)](https://www.bankofengland.co.uk/quarterly-bulletin/2014/q1/money-creation-in-the-modern-economy)
* [Where does money come from](https://www.goodreads.com/book/show/13144133-where-does-money-come-from)

> **Comments:**
> **username_6**: +1, this answer is more detailed, however: "What will limit the amount of money that is created are the banks’ profit considerations in the context of competition and macro-prudential regulation:". This is just fancy way of saying private banks **can** only create money from their reserves/capital buffer and *will be* created if bank finds creating them profitable (which is separate question from how they are created) . Sure profit  is one of the ways capital or reserves can be accumulated (as you mention in one other para) but without them private bank cannot create more money  money.  
> **username_6**: In addition the first bold sentence is wrong according to your own answer, even though the rest of the explanation is sound, since as you explain in your answer banks cannot create money out of thin air, they can only do that within the constraints imposed by central bank from capital/reserves  
> **username_7**: -1 by me the first sentence is blatantly false, I don't care how well rest is written. You should read Rendahl & Freund https://voxeu.org/article/banks-do-not-create-money-out-thin-air  
> **username_5**: @csilvia: Just because someone else says the opposite doesn't make it false. What's wrong with my reasoning? Btw, I admit that "out of thin air" is not scientific, open to interpretation, and may have a provocative touch.  
> **username_5**: @1muflon1: Appreciate it. There is a difference, though. Answering the question how are banks creating money (referring to the process) is different vs how much can they create and at which speed? How is unaffected by reserve amounts or capital requirements, whereas they matter for the maximum amount and speed.  
> **username_7**: @BrsG the problem is that it is wrong. Also, it is not about someone else saying something. In literature, creating money out of nothing is understood as being able to expand money supply without any constraint like central bank that can *actually* create money out of nothing. Commercial banks create private money by transforming an illiquid assets into a liquid ones, that is not out of thin air. Claim that private banks create money out of thin air also leads to whole plethora of garbage monetary theories so it is important claim. if you rephrase that sentence I can change my -1 to +1.  
> **username_6**: @BrsG no how is affected by this since it suggests that private bank can only produce money from high powered money. Saying its created out of nothing is incorrect, if it is created using some other instrument. Take an analogy, if firm producing totems can manufacture 10 totems out of piece of wood, the totems are not created out of nothing just because in one time period firm only uses 50\% of its wood inventory and creates only 5 totems and then uses rest of that inventory in next accounting period. The same holds for capital/reserves. Banks can only create money from high powered money  
> **username_6**: (e.g. capital/reserves) just because in one time period they have excess capital  that does not mean that up until they get to the limit they are not creating money from that capital. That just means they did not exhausted their 'inventory' of high powered money. Or are you seriously want to suggest that banks can create as much money as they please without having any high powered money (like capital or reserves)?  
> **username_0**: @BrsG Thanks for your answer.  To pick up on a small part of it - does it follow that it makes a difference to a loaning bank whether the recipient of the loan withdraws that loan in cash, or tries to transfer it digitally to another bank (which needs settlement with central bank reserves)? Or do banks get cash by ‘buying’ it with their central bank reserves balance?  
> **username_5**: @JCW: yes, for physical withdrawals, banks simply convert some of their reserves at the central bank into currency and have it delivered to them. Of course, they usually keep a certain amount on site, only only exchange net amounts with the central bank.  
> **username_5**: Edited my post: (1) Changed header, because the interpretation of "out of thin air" is contentious; (2) added two bits on collateral (this was previously only implicit in risk and profit considerations; (3) added image.  
> **username_5**: @csilvia: edited my post to *explicitly* encompass https://voxeu.org/article/banks-do-not-create-money-out-thin-air.  
> **username_5**: @1muflon1: Money creation works just fine without reserve requirements, provided other regulation is in place. that's why there is a trend of getting rid of reserve requirements. Also, reserve requirements, even if they exists, do not have much of an impact on money creation anymore, for example because some of the limitations can be "securitized away". The central bank will also normally provide, via OMOs for example, whatever reserves are required in the banking system as a whole, given its policy rate.  
> **username_6**: @BrsG 1. well yes but capital requirements/capital buffers are just reserve requirements with different name. So this is moot point. On a conceptual level there is no difference between regulation that states you have to have 10% reserves for every loan you give out, or you have to have 10% *capital* set aside for every loan you give out. 2. Also nobody is saying money in principle could not be created out of thin air, but under current capital requirements regulation *private* banks are **not allowed to create money out of thin air.**  
> **username_5**: @1muflon1: Capital requirements are different because they apply to categories of riskiness, ie the risky part of the loan, so there is not much of a limitation for low-risk loans. In the sense that it focuses on risk, capital requirements are smarter. And you get much more loans for the same 10%. Ultimately, limits can obviously bind.  
> **username_6**: @BrsG no I completely agree on this point, but again think about it on conceptual level. We could just make different reserve requirements per different categories of risk and it is literally the same as these capital requirements. And I 100% agree that capital requirements are smarter, better and completely support the shift from reserve requirements to capital requirements. But lets not pretend that capital requirements some exotic new policy. They are just reserve requirements applied in a smarter way on fundamental level  
> **username_5**: @1muflon1: Absolutely.  

---

### Answer by username_6 on 2021-07-15. Score: 2

> where does it actually come from?

The money comes from the reserves (note not in 1:1 ratio necessarily - the ratio of reserves to money is typically very small actually) provided by central bank (or possibly from other private bank that happens to have excess reserves/capital), and the reserves themselves are created out of nothing by government decree by central bank (hence why it is called fiat money). If a bank lends out money, and the lending is not made from deposit, then it has to ask central bank for enough reserves to maintain its reserve requirements (or in present day capital requirements since reserve requirements were abolished but capital requirements work in analogous way).

You can have look at [McLeay et al 2014](https://www.bankofengland.co.uk/quarterly-bulletin/2014/q1/money-creation-in-the-modern-economy) for more detail (although the paper is bit out of date nowadays due to abolishment of capital requirements and in some places uses bit non-standard terminology).

> Is the money being lent out 'real'?

Of course it is. You can use the money for everything you can use coins or notes in circulation for. In addition, ultimately all fiat money comes from government whether it be central bank (or in some countries like US, both central bank and federal government since mint and bureau of printing is technically part of US treasury).

> Is the act of a bank granting a loan intrinsically different from, say, you or I doing so?

In what way? Banks can endogenously increase money supply by asking central bank for additional reserves, if they face high demand. An individual cannot do that. Obviously, there is also more complexity in bank loan than in individual loan because of all the institutional context.

> **Comments:**
> **username_0**: Thanks for your reply.  Clearly, once the money has left the auspices of the bank, it is indistinguishable from money acquired any other way.  But before that, at the moment of the loan’s approval, doesn’t the bank effectively give itself permission to let more of its limited supply of ‘hard cash’ out into the world, by recording on its balance sheet that it has traded some of its cash for a future income stream of greater value?  Are you saying that it can keep going, issuing more ‘hard cash’ than it ever possessed, by drawing on central bank reserves?  
> **username_6**: @JCW most money is digital not in cash, if banks gives out loan it does not actually hand you bag with a \$ sign on it full of bills, it sends it to your account. Also, supply of physical cash is not really limited, banks can order more of that stuff it there is insufficient of it to circulate (here is an explainer on how the cash works https://www.newyorkfed.org/aboutthefed/fedpoint/fed01.html). If more cash is needed more can be always printed out, but nowadays people typically just keep money electronically most loans are never even cashed in the literal sense of that word.  
> **username_2**: Your first paragraph gives the impression that the amount of reserves required to make the loan is equal to the amount of the loan itself. This is generally not true. Indeed in general the amount of reserves needed to make a loan is a tiny fraction of the size of the loan.  
> **username_6**: @Mick I never stated that they are equal, you are right that amount of reserves is only small fraction, but they are needed and generally banks don’t have reserves just laying around so if they face extra loan they need extra reserves  
> **username_2**: By saying "The money comes from the reserves" you give that impression. A truer answer would be more like: "3% comes from reserves 97% is created out of nothing".  
> **username_6**: @Mick no what you say is completely incorrect if you would actually read literature, if we want to go into detail correct way would be stating \$1000 come from \$10 (or whatever reserves are required) not from nothing since the 97% (or whatever the true share is) cannot exists on its own without the 3% and is derived from it. So yes money literally comes from reserves not in 1:1 ratio, but I never claimed it did  
> **username_2**: I was just quoting Adair Turner... even truer would be 3% from reserves, 97% is created from converting the borrower's non-spendable IOU (the borrower's promise to pay the principal back to the bank) into a spendable IOU (the demand deposits).  
> **username_6**: @Mick anyway I updated the caveat about 1:1 ratio in my answer, but still all loan comes from reserves  
> **username_6**: @Mick but it still comes from reserves. Let me give you analogy if firm has production function Y=10L so 1 unit of labor gives you 10 unit of output, did 9 units of output came out of nowhere and 1 from labor? No all of them came from labor. Reserve is necessary input for any loan. The loan value does not come out of nothing it comes from the reserves. Central bank reserves come out of nothing not private loans. The quote just describes a process how reserves can be turned into more money, that more money still originated with the reserves  
> **username_6**: @Mick for example no matter what’s the borrowers future streams of cash flows are if banks has no excess reserve, and central bank is not playing ball and refuses to create new reserves, no new money can be created, loan cannot be given out otherwise bank would violate capital requirements regulations. Only if the bank has sufficient capital/reserves new loan can be extended. Of course not necessarily in 1:1 ratio, but reserves are necessarily  
> **username_2**: Both reserves and the borrower's promise to repay, are necessary ingredients in the loan so to ascribe the source of the loan to just one of the ingredients is misleading.  
> **username_6**: @Mick sure for loan to exist there must be demand for loan, but the money for that loan come from high powered money not from nothing that’s the point  
> **username_2**: The words: "(note not in 1:1 ratio necessarily)" gives the impression that it's at least in the same ballpark as 1:1 which is false.  
> **username_6**: @Mick how does it give that impression? Now you are stretching it anyway I will edit my answer to also clarify that the ratio of reserves and money is typically small  
> **username_0**: @1muflon1 But in practice, the decision to grant the loan is made independently of the subsequent inter-bank settlement in net flow of central bank reserves between banks, so I don’t see how your claim about the ‘source’ of the loan can be true.  
> **username_8**: "generally banks don’t have reserves just laying around" may have been true before 2008 but the position may have changed: see https://fred.stlouisfed.org/series/TOTRESNS  
> **username_6**: @JCW no it is not independent. Post 2008 central banks decided to pursue policy of providing as much liquidity (reserves) as private banks want. But that is literally central bank policy, if central bank would tomorrow decide, sorry guys no more reserves, then private banks cannot issue more money than what they can with their current level of reserves they would literally violate the law. Also just because in practice timing is different that does not mean the statement is not true in practice often  final manufacturer makes sale before even having materials. That does not mean you can produc  
> **username_6**: Produce stuff out of nothing  
> **username_2**: The sentence "Banks can endogenously increase money supply by asking central bank for additional reserves, if they face high demand." is misleading. It gives the impression that the increase in the money supply is one and the same thing as the increase in reserves. Not true.  
> **username_0**: @1muflon1 Ok, to be concrete: I’m British and most familiar with the UK economy. Can you identify a concrete statement of the capital requirement regulations that apply for the UK banking system?  
> **username_6**: @Henry that’s total for the whole banking system there is still a lot of heterogeneity on bank level many individual banks will still work with very little to none excess reserves but otherwise your point is correct that prior 2008 there were virtually no excess reserves, but even now many depository institutions try to keep as little excess reserves as possible it’s simply bad for their profitability, also some of that was because capital requirements were in some cases higher than reserve requirements now that banks have no reserve requirements the extra capital above cap req is not as large  
> **username_6**: @jcw the capital requirements in the UK differ by bank type and also by their balance sheet structure, you can read about that here https://www.bankofengland.co.uk/statistics/details/further-details-about-banking-sector-regulatory-capital-data  
> **username_6**: @Mick what are you talking about? 1. Reserves are literally part of money supply. 2. If broad money supply increases endogenously reserves have to be increased to maintain the reserve requirement. This literally holds in endogenous money supply model so how is that misleading?  
> **username_2**: Slightly depending on exactly which definition of the money supply you choose... a 100 dollar loan may increase the money supply by about 100 dollars but only necessitate an increase in total reserves of less than 5 dollars  
> **username_6**: @Mick but again I am never stating that the money supply increases 1:1 and already I literally stated at the start of my answer that the ratio to reserves and money is not 1:1 I am talking only about increases dM>0 requires dR>0, at this point it looks like you are not arguing in good fait but just for arguing sake, in the first reply I guess I can kinda see how someone could think without clarification that R:M=1 but since that was already cleared in the first paragraph you are just repeating yourself, the answer already clearly explains ratio of R:M is not 1  

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### Answer by username_3 on 2021-07-17. Score: 2

Each bank has a Chart of Accounts including accounts that are designated Assets, accounts that are designated Liabilities, and the difference between Assets and Liabilities is Owner's Equity or just Equity.

This four page pdf paper shows a simplified balance sheet and income statement for a fictional bank:

[https://www.richmondfed.org/~/media/richmondfedorg/publications/research/economic\_brief/2012/pdf/eb\_12-03.pdf](https://www.richmondfed.org/%7E/media/richmondfedorg/publications/research/economic_brief/2012/pdf/eb_12-03.pdf)

where Assets equal Liabilities plus Equity in the balance sheet. The reserves for loan loss account (also known as the loan loss reserve or LLR) is considered to be a contra-asset account. If one makes this account equal to zero then the assets would increase by that amount and the Owner's equity would increase by the amount in the LLR. So the loan loss reserve is a way to anticipate an expense charge against equity claims in the event that there is a default loss in the loan portfolio. Therefore equity claims on banks are reduced when loan defaults occur. Deposit levels are not directly coupled to loans or defaulted loans due to the equity market which drains deposits to create equity claims on the Liabilities and Equity side of the bank and aggregate Bank sector balance sheet.

This ten page pdf paper describes how banks create money and then also borrow money to keep interbank payments flowing in the reserve payment system:

<https://think.ing.com/uploads/reports/Money_paradox2.pdf>

Assuming the government does not print and spend physical currency to cover its deficit spending then new money must be created primarily via legal and accounting customs in the aggregate bank sector. When each bank issues a new loan it increases Loan Assets and increases Deposit Liabilities. This is stated as "Loans create deposits." However any time a bank loans money or makes a credit entry to the deposit account of a non-bank counter-party this is the creation of bank deposit money via accounting and legal customs. When a non-bank pays a bank via the decrease of deposit money in their account this is destruction of deposit money via legal and accounting customs.

The Cash account(s) for a bank consist of vault cash (notes and coin for servicing withdrawals) and of reserve balances at the central bank. Banks use Reserve Balance Assets to make interbank payments. The central bank must provide all the Reserve Assets necessary to service the currency drain and to clear interbank payments via daylight credit. If the central bank wants to limit the credit issued by banks it can attempt to restrict the amount of Reserves in the aggregate bank sector and impose regulations on the bank sector if operating as the primary regulator. However in a systemic crisis or banking panic the failure to provide all the Reserves necessary to operate the payment system and service the currency drain would have adverse consequences for the credit system as a whole and for the transactions in the real economy.

When the federal government deficit spends in the United States it sells Treasury securities to cover the difference between spending and taxes. The so-called "National Debt" is mostly issued as the float of Treasuries which must roll-over and grow if the government continues to spend more than it taxes on average over the history of the nation. However these Treasuries are considered to be risk-free assets of their owners and in the economic sense of term they are "economic substitutes" for government insured bank deposits. When a student borrower in the United States defaults on an direct federal loan or government guaranteed student loan the Federal government would either have to collect taxes or fees to offset this loss or allow the Treasuries float to increase while making a decrease of the government net worth if the government writes off the loan.

Suppose loans default in the private sector. The bank must write down its equity when the loan defaults and it writes off the asset. So the banking system allocates the "sins" of financial default to the reduced rate of increase of equity. Since bank equity drains deposits via the equity markets the write-off of defaulted loans against equity means deposits do not persist in perpetuity when corresponding loans default. However in a systemic banking crisis the government is forced to bailout the bad debts in the bank sector and to insure more deposits to keep the payment system operating and to ensure that the real economy is not cast into another Great Depression caused by systemic defaults and financial panic. So in a systemic crisis the loan defaults will not consume the equity of the bank sector if the government institutes policies to recapitalize the aggregate bank. Then one might argue or recognize that deposits persist as deposits rather than converting into equity or uninsured deposits which would absorb the write-off of bad loans in the aggregate loan portfolio.

A rational policy for a modern nation that does not want to bailout bad debts would be to force the super-wealthy to write off their financial net worth rather than increase the Sovereign debt. This would be a modern Jubilee where in ancient times the King would force the wealthy to write off bad debts to reset the economy. However the modern financial system makes it almost impossible to force those with vast wealth to take a write-off through the financial sectors. This is a political problem in the legislature caused by the complexity of industrial credit systems and financial intermediaries.

> **Comments:**
> **username_1**: +1 really interesting point about equity absorbing loan defaults resulting in a net-zero effect on total deposits.  I don't really understand what you're proposing in the last paragraph though.  Are you saying make jeff bezos buy the bad mortage backed securities in 2008?  
> **username_3**: Financial intermediaries (banks or non-banks) hold a portfolio of financial assets while issuing a mix of insured debt, uninsured debt, and equity. If there is a large unexpected default in the asset portfolio the insured investors get to keep their investment funds; the equity investors take the first loss; and the uninsured debt investors take the next loss. Demographically the super-wealthy have positive net worth independent of the valuation of real estate and leverage caused by the financial intermediaries issuing debt against collateral. So only those investors could take the write-off.  

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### Answer by username_9 on 2021-07-15. Score: 1

The money is """real""" in the sense that it's *backed* by "real money" even though it's *not* "real money".

Think about this: You go into a bank and ask for a \$1,000 loan. They say yes. They update their database - now their loans are \$1,000 more and your balance is \$1,000 more. So far, no "real money" has been involved.

But then, you go to the teller and you say "I'd like to withdraw \$1,000 please." *Now* they have to give you $1,000 of cash. And they aren't allowed to print that cash - that cash is "real money" to them.

Maybe you don't want cash. Maybe you want to buy a cheap car, so you use your card, and now your balance is \$1,000 less and the car seller's balance is \$1,000 more. And now the car seller may go to the teller and ask for \$1,000 of real money.

The fact that your bank balance may be converted to real money at any time is what gives it a real money value.

In any case, after the withdrawal happens, the bank is now down \$1,000 of real money, even though they have the same total balances in accounts, and \$1,000 more of loans. The bank has to keep a close watch on the account balances people have, versus the amount of real money they have. If their account balances are too high compared to their real money, they can't make more loans.

If they do make more loans anyway, it puts them at risk of bankruptcy, and they don't want to do that because bankruptcy makes their shareholders lose money.

> **Comments:**
> **username_0**: Thanks for your reply.  I understand this presentation of the concepts.  But I still don’t quite see how it can work like this in practice.  We know that banks don’t actually have enough assets to convert their entire balance sheet simultaneously to ‘real’ cash, so your ‘The fact that…’ line seems wrong?  And we also know that some non-negligible amount of debt is never repaid.  That is, the bank would on average release more ‘real money’ into the economy than it gets back - *except* that it also collects interest payments. Does the bank therefore rely on total interest exceeding defaults?  
> **username_9**: @JCW Well, yes? Of course they rely on interest exceeding defaults. Otherwise they'd gain nothing from the loans.  
> **username_9**: @JCW And yes, there are strict regulations on banks to make it so they're extremely unlikely to run out of real money, and there are other regulations to make it so in the unlikely even they *do* run out of real money, the government can print some for them (but they have to pay it back later!). Before these regulations were put in place, a bank collapsed and all its customers lost their savings *every week*.  
> **username_0**: Of course they expect interest to exceed defaults at the point of granting the loan, but given what we know of the economic cycle, it is almost certain that there will be periods in the lifetime of a typical mortgage (say) when aggregate defaults will exceed aggregate interest.  Is this why banks reduce lending during financial downturns?  
> **username_9**: @JCW Sure, and also why they build up savings when things are good, same as any business that doesn't want to go bankrupt. I think that part can just be analyzed as business profits/losses.  
> **username_8**: @JCW in effect the money has come from the bank's willingness to create an asset and a liability when lending to you.  This comes with a risk, and the bank's willingness to take risks affects how much they are prepared to do this.  In 2008 the banks found they were in a much riskier position than previously thought and cut back on lending.  In 2020 that did not happen, and the banks remained willing to make loans, though many potential borrowers were themselves unwilling to take risks of new loans during lockdown.  
> **username_0**: @Henry OK, but there are two factors affecting the volume of loans a bank might be asked to make: the eligibility criteria (typically based on credit rating etc) and the proportion of people meeting those eligibility criteria who choose to seek a loan (largely based on the macroeconomic context).  Strictly it also depends on the relative favourability of different banks’ offered terms.  None of these factors is directly connected to what the bank actually needs to fulfil the loan (sufficient central bank reserves for interbank clearance)! How can this be?  
> **username_0**: For instance, if from tomorrow all loan applications nationwide that would meet Bank A’s loan criteria went to Bank A, perhaps from a successful marketing campaign or generous terms - Bank A might be perfectly happy with the level of credit risk of all the assets it’s creating, but it still doesn’t necessarily have the resources to grant all those loans together itself (or does it?)  
> **username_8**: @JCW risks accumulate, and (as seen in 2008) some risks can become correlated, so if there is a limit to how much risk a bank can take both for internal policy and due to external regulation, so there is a limit to how many loans a bank is prepared to make at any one time  
> **username_9**: @JCW The bank has to estimate how many deposits people are likely to want to withdraw all at once, apply a safety factor, and then not make more loans than that. If the bank doesn't check for each loan, they've probably discovered that they don't make enough loans in one day to justify the effort of checking each loan individually. If they go slightly over their limit, it may be fine as long as they can borrow some reserves from another bank in exchange for non-reserves.  

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