How Do Banks Create Money Through Lending?

TL;DR

Commercial banks create most money by issuing loans and recording new demand deposits in customers’ accounts. In 2010, commercial bank money represented 97.4% of the UK money supply, while physical cash represented only 2.6%. Loan creation expands the money supply, loan repayment destroys commercial bank money, and banks retain the interest as profit.

Transcript

How is money created? Where does it come from? Who benefits? And what purpose does it serve? Back up, you [ __ ] What is a money system? What is the money behind the money system? For centuries, the mechanics of the monetary system have remained hidden in the prying eyes of the populace. Yet its impact both on a national and international level is ... Read More

Key Insights

• Commercial bank money constituted 97.4% of the UK money supply in 2010. Of the £2.15 trillion total, approximately £2.1 trillion existed as commercial bank money, while physical cash represented £53.5 billion, or 2.6%.
• Banks create new commercial bank money when they issue loans. The loan simultaneously expands bank assets and records a demand deposit in the borrower’s account, producing electronic money that enters circulation when the borrower spends it.
• Commercial bank money is destroyed when borrowers repay loan principal. The accounting process reverses the earlier creation of money, reducing the amount circulating in the economy, while the lending bank keeps the interest payments as profit.
• Physical currency generates seigniorage for the government. The Bank of England can produce a £10 note for approximately three or four pence, sell it to a commercial bank at face value, and transfer the resulting profit to the Treasury.
• The Bank Charter Act of 1844 removed private banks’ authority to issue paper notes after excessive issuance contributed to inflation and economic instability. The legislation did not cover the electronic demand deposits that later became the dominant form of money.
• Demand deposits are accounting entries held in bank accounts. They function as the electronic money used through debit cards, ATM cards, and transfers between computer systems, rather than as physical currency stored separately for each customer.
• Banks can create money through transactions beyond conventional lending. Extending credit, buying existing assets, and making payments on their own accounts can expand bank assets and create corresponding deposits within the commercial banking system.
• The UK money supply tripled between 1998 and 2007 as banks created £1.2 trillion. By comparison, the Treasury generated £18 billion over a decade from creating physical cash, illustrating the difference between electronic and state-issued money creation.

Questions & Answers

Q: How do commercial banks create money through lending?

Commercial banks create money by extending credit and recording a new demand deposit in the borrower’s bank account. The deposit is an electronic accounting entry rather than existing cash transferred from another saver. When the borrower spends the credit, the newly created commercial bank money enters circulation and can be used for payments throughout the economy.

Q: What percentage of UK money was created by commercial banks?

In 2010, commercial bank money accounted for 97.4% of the UK money supply. The total supply stood at £2.15 trillion, with approximately £2.1 trillion existing as commercial bank money. Physical cash amounted to £53.5 billion, representing only 2.6%, which shows that electronic bank deposits had become the dominant form of money.

Q: What happens to money when a bank loan is repaid?

When a customer repays the principal of a bank loan, the corresponding commercial bank money is destroyed. This reverses the accounting expansion that occurred when the loan and demand deposit were originally created. The bank does not retain the repaid principal as circulating money, but it keeps the interest charged on the loan as profit.

Q: Why are bank deposits considered money?

Bank deposits are considered money because people use them directly to make payments through debit cards, ATM cards, and electronic transfers. They appear as numbers within computer systems and can move between accounts without becoming notes or coins. The documentary identifies these accounting entries as demand deposits and, more formally, as commercial bank money.

Q: How does physical money creation benefit the UK Treasury?

Physical money creation benefits the Treasury through seigniorage. The Bank of England can print a £10 note for approximately three or four pence and sell it to a commercial bank for its £10 face value. The difference becomes government revenue, reducing the amount that otherwise needs to be raised through taxes. Over ten years, this generated about £18 billion.

Q: Why was the Bank Charter Act of 1844 introduced?

The Bank Charter Act of 1844 was introduced after private banks expanded their issuance of paper notes too far, contributing to inflation and economic instability. Robert Peel’s Conservative government transferred the authority to create paper notes from commercial banks to the state. Since then, the Bank of England has been the only organization authorized to issue those notes.

Q: Do banks simply lend money deposited by savers?

Banks do not operate only by transferring an existing saver’s money to a borrower. According to the documentary, a bank creates new commercial bank money when it makes a loan, recording the amount as a demand deposit in the borrower’s account. This differs from the common belief that deposits merely remain stored or are passed directly between customers.

Q: How can banks create money without issuing a loan?

Banks can create new commercial bank money when they buy existing assets or make payments on their own accounts, as well as when they extend credit. For example, when a bank purchases a corporate or government bond, it adds the bond to its assets and increases the seller’s bank deposit by a corresponding amount, creating new money.

Summary & Key Takeaways

• Most money used in the UK is electronic commercial bank money rather than physical notes and coins. In 2010, the total UK money supply was £2.15 trillion, of which £2.1 trillion, or 97.4%, was commercial bank money. Physical cash accounted for £53.5 billion, or only 2.6%.

• Commercial banks create money by extending credit and recording demand deposits in bank accounts. The new money enters circulation when borrowers spend it. Repaying the principal destroys commercial bank money, while banks retain interest as profit. Banks can also create deposits when purchasing assets or making payments on their own accounts.

• The documentary argues that control over money creation affects government revenue, financial stability, asset allocation, and the wider economy. Between 1998 and 2007, banks created £1.2 trillion as the UK money supply tripled, while the Treasury created £18 billion through physical currency over a decade.