How does a bank create money out of promises?

Total:  $100 + $95 loaned to Zeke are now on the books.

Total:  $100 + $95 loaned to Zeke + $90.25 to Jane are now on the books.

Total:  $100 + $95 loaned to Zeke + $90.25 to Jane + $85.74 to Zeke are now on the books.

We have done three cycles of loans, keeping 5% of each deposited loan. We now have a total of $370.99 in our banking system.

The banker who gives the loan has to decide, “Do I believe this borrower will pay me back?”

The borrower who gets the loan has to have a plan that will allow the loan to be paid back.

Together, they create money out of promises that the borrower makes.  This “new money” appears out of the minds of both parties.

9 thoughts on “How does a bank create money out of promises?”

  1. Sorry but I didn’t really understand, but how are the banks creating money above? They seem to be just rolling one loan into another and also taking a loan to make a deposit doesn’t make sense to me.

    • Well, you need to step through what I show a bit more. I’ll say a few things and suggest an exercise.

      Let’s say that you want to buy a car and you receive a loan of $20,000 from a bank. What happens to that money? Technically, you ‘receive’ the loan of $20,000 and instantly pay the car dealer. In reality, you don’t see the $20,000. That money is deposited into the bank account of the car dealership. Now you have the car and you have to pay the loan off on that car.

      What you need to think about is this – where did that money come from? And where did it go?

      That money was created by a loan. When the bank makes that loan, the money it loans out is taken from its capital account and put into a suspense account. The bank still has the money it loaned out as an asset. That asset is ‘worth’ the present value of the loan payments that you have agreed to make. The bank can sell that loan to someone else. When the bank sells the loan it made to you to someone else, it accepts some cash amount that allows the buyer to still make money on the loan interest. *The point here is that even after making the loan, that money loaned out is not ‘gone’ it is on the books of the bank as a productive asset.

      But the money given to you, that you gave to the car dealership is deposited into a bank account somewhere. And this fact is the key to understanding why banking is important. When it is put into a bank account as a deposit, that money becomes NEW capital that the receiving bank can use!

      This is a bookkeeping fact. Around 600 years ago this practice began. It could begin because it wasn’t safe to keep gold coins around the house. Back in Florence, Italy, when banking started, there was little law. Gangs would attack a rich man’s home, steal his money and his daughters. Today in downtown Florence you can see these old homes. They are tall, with stone walls and places to pour boiling or burning oil down on top of attackers. As a result, a few very rich men with bigger, stronger palaces were trusted to hold gold and jewels for other people.

      That ancient system in Italy is very close to the modern day hawala system. Today, if someone wants to pay or transfer money overseas, they might go to a hawala man. They give him the money to transfer, and he tells another hawala man to pay someone far away. Just imagine that there are no police and roving gangsters can rob anybody weaker than they are. You would be happy to give all your money to the hawala man if you trusted him. Today, this is done by email or telephone. But in the ancient times it was done by letters of credit with an official seal.

      Even today, banks issue letters of credit for certain large commercial transactions.

      For a long time, such families would issue a letter of credit and that is all. They carefully accounted for every gold, silver or copper coin and jewel they had in their vault. They never went over it. They treated the letters of credit as a substitute for ‘real money’ coins.

      But a family in Florence started ‘cheating’. They started giving out letters of credit when they didn’t have money in their vault for it. And they realized that nobody knew! They also realized that giving out money they didn’t have in their vault made them rich and powerful. Go to Florence (Firenze) and see the Uffizi and the square and the Pitti Palace. They issued their own scrip they called the ‘Florin’ backed by the contents of their vaults. They could print as much as they wanted. It made them fabulously rich.

      And those early accountants noticed something interesting. If they gave a loan to someone in town, and that person deposited the loan money into an account at their bank, they ‘found new money’. It was money on the books.

      But this accounting trick could never happen if all money was physical.

    • The exercise you should do is take two sheets of paper.
      Write Bank 1 at the top of one sheet and Bank 2 at the top of another sheet of paper.
      Make two columns on each sheet of paper. Capital & Suspense

      Start by writing $100 at the top in Bank 1 in the ‘Capital’ column.
      Then make a loan of $95 to someone.
      Write $95 into the Suspense column pf Bank 1.
      Cross out $100 in Capital, and subtract the $95 from it. So your new Capital total is $5. Circle that $5 as reserve. You must keep it in the bank from now on.

      Write the loan amount of $95 into the Capital column of Bank 2. Now make a new loan from Bank 2. Multiply $95 by 95%. See if you can get the accounting correct – do it just like you did for Bank 1. Because as far as Bank 2 is concerned, that $95 deposited is ‘just money’.

      Step through the exercise multiplying the amount of capital available at the bottom of the capital column by 95%. Take it as far as you can.

      Add up the totals. See what happens.

      • I am pleasantly surprised by your quick reply, I didn’t expect one so soon, if at all. Thank you.

        I did what you said, not on paper but on excel, about 20 iterations of those calculations gives me the following at the end-

        Banl-1 Capital = $806.6849
        Bank-1 Reserve = $40.3342
        ~~~~~~~~~~~~~~~~~~~~~~
        Bank-2 Capital = $766.3507
        Bank-2 Reserve = $42.4571

        Well, as I understand the banks among themselves already have (40.3342+42.4571) = $82.7913 of the initial $100 of seed money. But loans outstanding are $861 and $806 respectively. This has become more weirder than before now :(

      • That looks about right Kiran. Yes, it’s not intuitive for most people.
        I’ll try to put up a spreadsheet. But I’m not sure if that will work in WordPress. Worst case, I’ll put up a jpg of it as an additional page.

        If you get this down, you can take a look at the mathematics for geeks page that has the summation equation and graphs. Note that when you are looking at the graph, it is something of a monstrosity. By that I mean that in the real world, as you saw in your spreadsheet, increase in money supply through making loans is discontinuous, it works in jumps. But the graph is smooth, as if the function were continuous. But – it works, and with calculus you can show that the area under the graph is the same. A lot of this is conceptual.

        Of course, in the real world things are not quite this clean. In the real world, money is lost to the banking system as cash, or as some other non-productive hard asset. And in the real world today, the reserve that a bank needs can be acquired after a loan is made by going to the Federal Reserve (or some other central bank). But what you just did on your spreadsheet is see what the Medici family figured out in the 15th century that made them fabulously wealthy, the financiers of monarchs. They didn’t fall until King George lost the American revolution. The Medici’s had backed King George.

        Everything you look at pretty much exists because banks made loans to finance the manufacture and purchase of it. From the food you eat and the computer you use, to the carpet on the floor and the windows you look out of. Banking made the Western world what it is today. Without it, we would still live a medieval existence.

        And it’s all because of a bookkeeping trick. We agree to accept this money as being as real as any other. Therefore it is as real as any other. In fact, today, there is virtually no other type of money in the world.

  2. I don’t think I got it worked out because it’s quite obfuscated but anyway thanks for trying to help and the very interesting snippets of history.
    BTW, how does govt pump in fresh money into the system? I mean after it prints the money where does it go first?

  3. umm.. got a better understanding of this process after going though the Bernard’s video which you posted in another link.
    But if according to you other post, CRR decides how many times a bank can lend, why not reduce it so that they can go on lending more? In fact, what would happen if there was no CRR itself?

    • An excellent question. There are banking systems where no reserve is formally required, such as Canada. However, they maintain solvency with a method I haven’t studied yet. There may not be reserve requirements on certain deposits, such as time deposits, or the time deposits only require reserve sufficient to redeem some fraction of the time deposits when they come due. This actually makes sense, because if you are a bank and someone gives you a time deposit for 20 years, you know that they won’t be taking it out, so why would you need reserves?

      In practice, you need a little bit, because sometimes the depositor needs their cash. Thus the penalties against interest for early withdrawal.

      One of the things that happened when AIG stopped being able to pay off credit default swaps is that the banking system ran out of money to service redemptions and basic wire transfers. This was because the real ratio due to using credit default swaps was on the order of 1500:1. In other words, like having a reserve of 0.06%
      If you want to understand that you can read: http://www.economics-ejournal.org/economics/journalarticles/2012-3

      A banking system that required no reserves would necessarily depend on agreeing to accept that the central banks would supply redemption money.

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