The way money creation works in an economy and how the commercial banking system operates is broadly misunderstood.
The way that it’s commonly taught in introductory economics textbooks is that a commercial bank takes in other people’s money (i.e., deposits) and then lends out this money in the form of loans. For non-bank financial institutions, this is more or less the process – i.e., other people’s capital gets used as collateral to issue loans or make investments.
However, commercial banks do not lend out deposits or any liability item on their balance sheet. Banks are not intermediaries whose business model is dependent on the savings habits of the non-bank public nor do they “multiply up” central bank money in order to create new loans.
Moreover, the amount of money created in an economy works through the monetary policy of the central bank. Normally, this is done through setting interest rates (primary monetary policy). Other times, this is done through asset buying or “quantitative easing” (secondary monetary policy).
The legal and economic lending capacity of commercial banks is predicated on the volume of business associated with creditworthy borrowers.
In the US, net changes in Reserve Bank credit, since 1951, have been determined by monetary policy, not the savings practices of the households and businesses. The implication is that commercial banks could continue to lend even in the non-bank public ceased to save altogether.
In the modern economy, bank deposits form the basis of most money. How this money is created or how it gets there is often laced with misperceptions. The principal way it gets there is through commercial banks making loans. Whenever a bank creates credit (i.e., lends), it will simultaneously create a matching deposit in the borrower’s bank account. This creates new money.
The common teaching purports that banks expand loans and deposits in accordance with a central bank operation that feeds reserves to banks, which then permits them to expand their balance sheets with new loans and reserveable deposits based on whatever reserve ratio is in place that constrains the expansion relative to reserves supplied. This is not accurate.
Commercial bank balance sheet expansion by and large occurs through the endogenous process wherein loans create deposits.
When a bank makes a loan to a borrower, that represents a debit (new asset) and a credit (new liability) to the deposit account of the same entity.
Operationally this is entirely separate from any notion of reserves that may be legally required in conjunction with the creation of bank deposits. The demand for and supply of reserves associated with such a requirement comes after the creation of the deposit, not preceding it.
Central banks impose reserve requirements and institute reserve levels as a matter of automatic operational response. But again, this occurs after the loan and deposit expansion that generates the requirement has already occurred. The money multiplier idea tries to claim that a central bank has direct exogenous control over bank expansion based on a reserve supply function, but this is not true.
Banks lend on their own on the basis of creditworthy lending opportunities. Reserve ratios are not a binding constraint.
People, companies, banks, etc., can create credit out of thin air.
For example, if you go into a store and buy a shirt with your credit card, where did that credit come from? It was created on the spot. You (the person buying the shirt) just created a liability for your own balance sheet, which will need to be settled with money down the line, and you receive the shirt in return as an asset. The entity selling the shirt just created an asset in the form of a receivable, which will be paid by the financial intermediary after a given number of days.
This also gets into the important differences between money and credit, which are typically used interchangeably because they are both mediums of buying power. But they are fundamentally different.
Money is what payments are settled with. Credit is a promise to pay. Credit creates debt. One person’s debt is another person’s asset.
Money represents reserves and currency. Reserves are bank deposits. These are assets to households and companies. They are liabilities to commercial banks. Currency is an asset to those who hold it and a liability of the central bank. Most money in an economy is in the form of reserves, or the money created by central banks themselves.
Loans create deposits (i.e., money). These are then backed by reserves after the fact, not before.
When a bank makes a loan, such as a mortgage used to purchase a house, it does not consummate this process by giving the borrower a bunch of currency or bank notes. Instead, their bank account will be credited with a bank deposit equal to the size of the mortgage. It is at this point that new money is created.
This contrasts with the typical erroneous perception that banks only lend out money that already exists within it. But bank deposits are not simply a record of how much money it owes its depositors. They are a liability, not a type of asset that can be lent out.
Another misperception is that banks lend out their reserves. They cannot lend out reserves to the non-bank public. They can only lend reserves between banks. Reserves can also be used between commercial banks to settle payments. The non-bank public does not have access to reserve accounts at the central bank. (This goes for the Federal Reserve, European Central Bank, Bank of Japan, Bank of England, etc.)
With that said, though commercial banks create money through lending, this is not a limitless process. The basic reason is that there is a point at which lending will no longer remain profitable in a competitive banking system. Many different lenders compete for the same opportunities.
Regulation is also a constraint to maintain the broader health of the financial system, such as to limit excess leverage. Households and companies that are the recipients of the cash from new lending can also “destroy” the money stock when they repay their debt (i.e., debt is a “short money” position – it eventually needs to be covered). The process of money destruction is covered further in the next section.
How money can be created and destroyed
The act of lending creates new money. Likewise, the servicing of debt destroys money when the IOU is covered.
In the example of a consumer buying a shirt in a store with a credit card, this is an act of credit creation. The store receives money from the financial intermediary (credit card company), while the consumer has a financial liability equal to the payment amount made on credit. They must eventually cover this liability, and they will do this by eventually paying the outstanding balance. (They also have the option to default.)
Every time the customer buys a product from the store on credit, this will increase the outstanding loan on the consumer’s balance sheet and receivables (a type of IOU) on the store’s balance sheet.
If and when the consumer pays off their credit card, the intermediary (i.e., bank) would reduce the deposits in the consumer’s account by the total amount of the credit card bill. This would effectively destroy all the money that had been created.
This general process of banks making loans and consumers repaying them is the most significant way in which money is created and destroyed in an economy.
But there are other ways in which the money creation and destruction process occurs.
When the central bank, or banking sector more broadly, buys or sells assets to or from the non-bank public, money is created or destroyed.
The same is true during the QE (i.e., central bank asset buying) process. The central bank and commercial banks buy and hold government bonds as part of their liquid asset portfolio. This portfolio can be converted to currency if depositors want to withdraw their deposits at a large scale.
Money is also destroyed when banks issue long-term debt and equity securities. Banks have some level of capital and long-term liabilities on their balance sheet. They do this to control risk for internal purposes. They must also adhere to certain regulatory requirements.
But these are also non-deposit liabilities and cannot be exchanged as easily as bank deposits. Therefore, these assets are considered of a lower level of quality for banks and will not be acceptable as collateral for certain types of regulatory capital provision matters (like reserves, government bonds, government-backed securities, and other types of capital that might be considered “high quality liquid assets”).
When banks issue these longer-duration debt and equity securities, companies in the private sector will pay for these securities with bank deposits. The decreases the amount of deposit (i.e., money) liabilities on the banking sector’s balance sheet and increase the level of non-deposit liabilities.
The nature of buying and selling assets and issuing longer-duration securities may cause discrepancies between the amount lent and the amount of deposits held if an economy is closed (i.e., not open to transactions with other countries, either goods, services, or financial assets).
Since most countries in the world are open economies and conduct cross-border transactions in a relatively free manner, deposits can move from domestic residents to foreign residents.
For someone in the US, a US dollar deposit can be converted into a foreign currency deposit, say into euros or British pounds. While conversion into a different currency does not technically destroy the money, foreign currency and overseas deposits will not always be included as part of a country’s broad money total.
Monetary policy is the ultimate constraint on money creation
Modern-day central banks have a statutory mandate to ensure the amount of money and credit in an economy are consistent with inflation that is both low and stable.
Typically, when monetary policy is set through interest rates (specifically, interest paid on reserves), this influences a host of other interest rates used for lending and other capital costs throughout an economy.
Even when the short-term interest rate is at its effective lower bound mark, credit and money creation in an economy may still be too low.
In this case, the central bank will begin to buy financial assets, mostly sovereign bonds, in a process typically referred to as quantitative easing, or QE.
QE works to boost the amount of money in the economy by directly purchasing assets from the financial sector. QE will initially increase the amount of bank deposits that the private sector institutions hold. To rebalance their portfolios, these entities will probably then go on to buy something similar in character. The more this process continues – by the central bank expanding the size and/or scope of its asset buying program – the more investors will eventually push themselves into higher-yielding assets.
This further lowers lending rates and capital costs across the economy when done on a sufficient enough scale. It will naturally raise the prices of these assets as prices and yield move inversely to each other. This creates a wealth effect both directly, and by making households and businesses more creditworthy because the price of collateral increases. Asset buying is most effective when risk and liquidity premiums are high, with the marginal returns becoming less effective as these premiums compress.
As a monetary byproduct of asset buying, new central bank reserves are created. However, they are not an important part of the policy transmission process. These reserves cannot be “multiplied” into more loans and deposits and are not “free money” that’s “handed out” to banks.
The price of loan funds (in addition to any fees charged), is the ultimate constraint on credit and money creation in an economy. Raising interest rates decreases the demand to borrow, while lowering them typically stimulates borrowing demand.
The three main constraints to credit and money creation
1. Banks can only lend so much
Banks need to be able to lend profitably. There are only so many profitable lending opportunities in a competitive lending marketplace.
Lending is constrained by both internal risk management procedures (designed to protect the firm, such as avoiding too much lending to a particular entity or a particular sector) and due to external factors like prudential regulatory matters designed to look out for the broader financial system.
2. Household and corporate behavior also have a direct impact on money creation
When households and banks service their debt, then money is destroyed, as covered above.
3. Monetary policy
Central banks influence lending rates throughout the economy and increase the net present value of financial assets (i.e., their prices). Lower interest rates make capital cheaper. This encourages households and businesses to demand credit because it reduces the hurdle rate necessary for their projects and other ventures to be economically viable.
Through this process of changing interest rates, the central bank is able to ensure that credit and money creation occurs at a level that is consistent with its statutory mandate(s). This mandate can include many different things (e.g., maximum output, currency stability), but generally targets low and stable levels of inflation.
From the perspective of the bank
Banks generate revenue by receiving interest on their assets, such as loans. They also have variable costs related to payments they need to pay on their liabilities, such as deposits (e.g., customer savings accounts).
The interest rates associated with the banks’ loans and the banks’ liabilities are dependent on the rate set by the central bank of the jurisdiction in which they’re located (e.g., the Federal Reserve for US banks, Bank of Japan for Japanese banks). This ultimately constrains lending and money creation.
Commercial banks use the spread between the expected return on their assets and liabilities to cover their fixed costs and to generate a profit.
To generate extra loans, an individual bank will often lower its lending rates to incentivize companies and households to borrow more.
If a bank makes a mortgage loan, the buyer receives a house (asset) and has the loan as a liability. The new money that was created and put into the buyer’s account may also likely be transferred to a different bank, assuming the buyer and seller don’t have accounts at the same bank. (Naturally, in a competitive banking system, the buyers and sellers will often bank at different institutions.)
Since the buyer’s bank would transfer deposits to the seller’s bank, this means the buyer’s bank would have fewer deposits than assets. This could potentially be an issue for the bank because it may lack the reserves to meet all of its future outflows. If a bank were to finance all of its new loans in this manner, it could run out of reserves, or its cash buffer it uses for capital adequacy purposes.
In reality, other banks are also making new loans, so the buyer’s bank would also be attracting some of these deposits created by other institutions. In general, banks would like to attract or retain liabilities that accompany the creation of new loans. This might mean increasing the interest rate they offer on savings accounts of cash deposits. When they attract new deposits, this allows the bank to increase its lending without running its reserves down too low.
Another possibility is for the bank to borrow from other banks, or borrow other liabilities temporarily. These liabilities need to be measured against the interest the bank expects to earn on the loans it’s creating (which is a function of the rate set by the central bank).
If a bank reduced its mortgage lending rates and attracted new borrowers, while at the same time increased the rates it was paying on customers’ deposits, it might soon find it unprofitable to keep expanding its lending.
This competition for loans and deposits and the need for banks to make a profit limit the credit and money creating capacity of the economy. In turn, this is why interest rates, and the short-term rates set by a central bank, are so important. And it’s also why it’s vital for traders to understand this process.
The amount spent – and what mediums were used to spend, as in the amount of money versus the amount of credit – divided by the quantity is ultimately what determines prices of goods, services, and financial assets.
How banks manage risks associated with lending
Of course, when banks make loans they know their interest income is not simply a weighted average of the loan volume and their respective interest rates. There are risks associated with them.
One way to mitigate risks is to attract a stable deposit flow to match their new loans. That is, deposits that are unlikely to be withdrawn in any substantial amounts. (Some misconstrue this as the deposits they lend out, but this, as covered above, is of course not how it works.)
If deposits held by a bank were of a nature that they were at risk of being withdrawn rapidly in a short period of time, such as instant access accounts, this would represent a source of instability. If such a liability structure were present, this could act as an additional constraint to how much a bank could lend.
Banks often tend to lend for periods that run for years, so the liquidity mismatch between its assets and liabilities would create a large degree of liquidity risk.
Banks protect against this by making sure that some of their deposits are fixed for a certain period of time. This also means that they might have to pay more for these because consumers want to be compensated for the inconvenience of having their deposits tied up for that long.
When banks pay more for one- or two-year cash deposits relative to standard savings accounts rates or for equivalent yields on government bonds, for example, this shrinks their net interest income spread (i.e., rates borrowed at versus the rates lent at).
Because these types of stable deposits are more costly, this constrains lending to a degree. Moreover, when banks safeguard against liquidity risk by issuing more long-term liabilities, this can actually destroy money when companies and households pay for them directly by using deposits.
Banks will also protect themselves against liquidity risk by holding various forms of reserves and currency, such as cash and cash-like assets like its own sovereign bonds (e.g., US Treasuries). In US regulatory parlance, this is known as high quality liquid assets (HQLA), as set by Basel III, a voluntary regulatory framework that focuses on capital adequacy.
These liquid reserves can be used to either cover any outflows or to easily (and inexpensively) convert into other types of assets. Banks can also purchase types of assets, such as sovereign bonds, that can be used to create additional deposits.
Lending is also constrained by considerations of credit risk. This is the risk associated with borrowers defaulting on their loans. Banks will have reserves available to guard against these losses. But at the same time, credit risk will be factored into the price of the loan. This normally comes in the form of a higher interest rate.
When a bank issues a loan, it will charge an interest rate that covers the expected credit losses the bank expects to occur. The less creditworthy the borrower is deemed to be (based primarily on income and indebtedness ratios), or the higher the expected losses, the higher the interest rate on the loan will be, holding all else equal.
When banks expand their lending, the expected loss per loan is likely to increase as it dips into riskier opportunities. They are also probably less profitable. And when banks can’t lend as profitably, money and credit creation is more limited.
This, in turn, is a constraint on the potential price appreciation in financial assets.
Limitations to risk protection
Banks are not always keen to adequately protect themselves from liquidity and credit risk due to natural market forces themselves.
Accordingly, this is why regulation is used to manage banking activities. Prudential regulatory frameworks are used to prevent banks from taking undue risks when creating new loans. This typically comes in the form of stipulating certain liquidity and capital ratios and position.
Regulation is also typically a damper on the economy’s money and credit creating capacity. This is why regulatory rollbacks are typically rewarded in the financial markets through higher stock prices. They, however, can lead to higher systemic risks. The best framework over the long-term will seek to balance market forces while ensuring broader financial stability through a macroprudential authority that can identify, monitor, and take action to mitigate or remove risks that threaten the health of the financial system.
How money and credit creation is limited through the behavior of households and companies
Constraints in money and credit creation will arise due to the response of non-bank entities – i.e., households and companies. Namely, how much money will households and companies hold relative to other assets, such as shares of ownership within a company, inventory, real estate, and so forth.
When money is converted into assets this has implications for things like inflation and the future path of asset prices. When less liquidity is available going forward – i.e., “cash is off the sidelines” – the central bank will need to recognize this to encourage further credit and money creation.
Some consumers and businesses will also want to service their debt early, which would leave less liquidity in the economy to spend on goods and services (i.e., less inflation in the real economy, ceteris paribus) and less to put into financial assets.
Monetary policy as a constraint
Central banks aim to ensure financial stability through a mandate that typically wants to keep inflation at a low, stable level. (Or some other form, like to maximize output within the context of price stability or to ensure stability in the domestic currency.)
The US Federal Reserve, Bank of Japan, and Bank of England target inflation at 2 percent. The ECB targets inflation at just under 2 percent.
Monetary policy is therefore conducted in a manner achieve this objective. Central bankers typically believe that inflation that’s left too low for too long will risk deflation, which could mean output is not being maximized and risks falling incomes, falling spending, and greater unemployment than necessary. Some level of inflationary pressure is thus taken as indicative that there is adequate demand being generated in the economy, but not to a degree where price pressures become excessively onerous.
In normal times, these central banks, as well as virtually all others, will implement monetary policy by setting short-term rates within a particular range (usually 25bps). This is typically done by setting the interest rate paid on central bank reserves that are held by commercial banks.
The central bank can do this because it has monopoly power over the provision of money in an economy. This concentration in power broadly isn’t viewed as an issue because economic actors usually have strong trust in the system. People can transact in alternative currencies if they wish, but when there is widespread trust in a currency as a medium of exchange and store of wealth, this will tend to occur on a very minor level.
Central bank money is the ultimate means by which commercial banks settle their payments. The price set on reserves has a meaningful influence on other types of interest rates in the economy. This is because the rate they receive on their reserves dictates the rate at which they’re willing to lend on similar terms in the money markets (i.e., overnight loans that commercial banks and other financial institutions lend to each other).
How central banks use the money markets to implement monetary policy has varied in terms of the mechanics – e.g., corridor system, floor system – has varied over time, and varies by jurisdiction. The rate that the central bank institutes influences various interest rates throughout the economy, such as what’s charged to various borrowers and the rate offered to savers on their deposits. The price of credit goes on to impact broad money creation throughout an economy.
In many teachings of economics, it’s taught that central banks determine the amount of broad money in an economy and central banks vary the quantity of reserves to set this level of money through a “money multiplier effect”. Under this view, the central bank chooses the quantity of reserves and these reserves “multiply” to represent an increase in the amount of lending and deposits.
But as we’ve covered, this narrative does not accurately reflect the relationship between monetary policy and money in an economy.
Some textbooks will also describe a spurious concept known as “money velocity”. Money velocity purports that you can obtain a higher GDP off the same monetary base if the money in an economy (supposedly) just circulates around faster. So, if money velocity is decreasing this is interpreted by some to mean that money isn’t being spent as quickly as it formerly was. But most spending in an economy comes from credit (promises to pay), not money (payment settlements). Increased money velocity is more accurately a greater expansion of private sector credit creation, not money being spent faster.
Central banks do not usually choose a level or quantity of reserves to target to set the short-term interest rate. Instead, they focus on setting the rate directly by supplying reserves (money) to the commercial banks and paying a set interest rate on those reserves.
The amount of reserves and currency in circulation, which together make up base money (sometimes called M0), is a function of banks’ demand for reserves. This demand is a function of the need to settle payments and to meet the demand for currency from its customers. Typically, the central bank can accommodate these demands.
Reserve requirements – or the idea that banks must hold a certain amount of reserves relative to their deposits – are not a particularly important aspect of current monetary policy in developed economies. Some don’t have reserve requirements altogether.
Credit and money creation when banks hit lower bound interest rates
When interest rates are at the effective lower bound, somewhere around zero percent (a little bit above or a little bit below depending on the central bank and how policy is implemented), commercial banks could create too little credit and money to be consistent with the central bank’s objective.
When the central bank is out of room, if they don’t find another way of stimulating credit and money creation, output will be weak, unemployment will rise, inflation will fall, and asset prices will decline.
Once the short-term rate is at its lower bound, whatever that’s deemed to be, the central bank will typically move onto asset buying. This program was pursued by the US during the Great Depression in the early 1930s, and by all major economies following the financial crisis in 2008.
Asset buying is particularly effective when asset premiums are high and thus have the capacity to be lowered. When this is possible, longer term lending costs can be lowered to support credit and money creation to stimulate economic activity.
Nonetheless, there is an important difference in the role of money between the two policies.
During an asset buying program, the central bank creates new money to buy a certain quantity of financial assets, usually government bonds. Sellers of these assets (the private sector), receive cash in return. They will end up holding more cash than they’d like relative to their other holdings, and will therefore be likely to buy other assets like higher-duration sovereign debt, corporate debt, and equities.
This acts to raise the value of these assets and lowers the costs of raising capital in these markets. In turn, this is likely to improve spending in the economy.
Contrary to popular misconceptions, asset buying programs do not a) give “free money” to banks nor do they b) increase lending because they provide new reserves to the banking system (a strain of the money multiplier theory).
The relationships between money and asset buying programs is different from primary interest rate policy (adjusting short-term interest rates). Asset buying impacts the amount of money in circulation through the way the central bank carries out the process, which is through electronic forms of money.
When a central bank buys assets, the holders of these bonds are often private sector entities like insurance companies and pension funds. Because these types of firms do not hold reserve accounts with the central bank like commercial banks do, the entity will use a commercial bank as an intermediary.
For example, the bank of the life insurance company will credit the life insurance company’s account with a certain amount of deposits in exchange for the government bonds. The central bank will finance the purchase by crediting reserves to the life insurance company’s bank. In other words, it provides the commercial bank with an IOU. The commercial bank’s balance sheet expands – the bank receives new reserves matched by the corresponding new liabilities.
Misperceptions over how asset buying works
a) Reserves are not “free money” for commercial banks
Central bank asset buying programs both involve and impact commercial banks’ balance sheets. But the primary role of commercial banks in the QE process is as an intermediary to facilitate transactions.
In the example above, the commercial bank intermediates the central bank’s operation of buying the government bonds from the life insurance company. The extra reserves that the commercial bank is left with are a byproduct of the transaction.
Indeed, commercial banks do earn interest on these new reserves. However, they are also accompanied by a corresponding liability (the insurance company’s deposit), which the bank will have to pay interest on. That is, the IOU from the central bank (new reserves) goes along with the IOU that goes to depositors.
The interest rate on both is heavily dependent on the interest rate set by the central bank. If the bank is looking for a more stable source of deposits, the spread between the interest earned on reserves could be lower than the interest paid on deposits – i.e., to incentivize the non-bank public to keep their deposits with them rather than putting them into government bonds.
b) The extra reserves are not “multiplied” into new credit and money
Central bank asset buying is transmitted through the creation of new electronic forms of money.
The transmission process begins through the creation of bank deposits as the asset replacing the government debt. The commercial bank obtains reserves, but these are not important to the process because commercial banks cannot lend out reserves.
They are an IOU given by the central bank to commercial banks, which can then be used to lend to each other or to settle payments. But they cannot be lent to households and businesses because they do not hold reserve accounts with the central bank. When banks generate loans, reserve quantities do not change. The loan amounts are matched by corresponding deposits.
Central bank asset buying increases money without directly requiring that lending increase. It is simply a system that alters the incentives by lowering other types of costs of capital in the economy (longer duration rates and the cost of issuing equity), thus stimulating the demand for borrowing.
This article covers how credit and money creation occurs in modern developed economies. The majority of money in circulation is not created by the central bank but by the commercial banks themselves (who are members of the central bank and have reserve accounts with it).
One common misconception, where the bank supposedly uses deposits to create loans, is actually backwards. Commercial banks do not depend on the savings practices of the non-bank public to lend. Rather, the amount of lending is contingent on the availability of profitable lending opportunities. The new money created when loans are made generate deposits.
The central bank is the ultimate constraint on this process through the way it sets monetary policy – i.e., by setting short-term interest rates or through the process of asset buying (when short-term interest rates are at their effective lower bound).
For traders, it is important to understand the process of credit and money creation in an economy. The prices of financial assets are a function of the total amount of money and credit spent on them in relation to the quantity.
This means that if you can accurately measure money and credit available to the buyers and the quantity sold by the sellers, you will be able to get an approximation of what the price of something should be. (It’s rarely a precise process, but it depends on what you’re trading. Something like equities are less precise in terms of what they’re worth in relation to shorter duration bonds, for example.)
Changing the demand side (money and credit available) is normally easier to do than changing the supply (amount or quantity sold) and central banks have a large amount of power over how this is done. Accordingly, traders need to be versed in how the money and credit creation process works and be up to speed on what the central banks are doing.