Overview

How Banks Create Money

The money that banks create isn’t the paper money that bears the logo of the government-owned Reserve Bank. It’s the electronic deposit money that flashes up on the screen when you check your balance at an ATM. Right now, this money (bank deposits) makes up over 86% of all the money in the economy. Only 14% of money is still in that old-fashioned form of real cash that you can touch.

Banks can create money through the accounting they use when they make loans. The numbers that you see when you check your account balance are just accounting entries in the banks’ computers. These numbers are a ‘liability’ or IOU from your bank to you. But by using your debit card or internet banking, you can spend these IOUs as though they were the same as £10 notes. By creating these electronic IOUs, banks can effectively create a substitute for money.

The following video from the Bank of England explains how money is created by commercial banks:

Every new loan that a bank makes in this way creates new money. While this is often hard to believe the first time you hear it, it’s common knowledge to the people that manage the banking system. In March 2014, the Bank of England release a report called “Money Creation in the Modern Economy”, where they stated that:

Bank-of-England-Money-Creation-Modern-Economy

“Commercial [i.e. high-street] banks create money, in the form of bank deposits, by making new loans. When a bank makes a loan, for example to someone taking out a mortgage to buy a house, it does not typically do so by giving them thousands of pounds worth of banknotes. Instead, it credits their bank account with a bank deposit of the size of the mortgage. At that moment, new money is created.” (Original paper here)