Loans Create Deposits

Ask a bank for a mortgage and a credit committee will weigh your salary against the price of the house. But here is what does not happen: nobody checks whether the bank has your £250,000 lying around. No saver's account is debited. No trolley of deposited notes is wheeled up from the vault. When the bank approves the loan, it types a brand-new deposit into your account, and at that moment there is £250,000 in the economy that did not exist the day before. This is not a crank theory from the internet: it is the Bank of England's own description of the system, published in 2014, to remarkably little fuss.

The textbook story goes like this: savers deposit money, banks lend most of it out, keep a fraction in reserve, and the 'money multiplier' does the rest. Neat, teachable, and backwards. In 2014 the Bank of England published 'Money creation in the modern economy' (McLeay, Radia and Thomas, Quarterly Bulletin Q1) stating flatly that banks do not act as simple intermediaries lending out savers' deposits, nor do they 'multiply up' central bank money. Lending creates deposits: "the reverse of the sequence typically described in textbooks". The people who run the machine wrote down how it works, in plain English, free to download. Most economics courses carried on regardless.

The mechanics are pure double-entry bookkeeping. When a bank grants you a loan, it marks up two entries simultaneously: an asset (your promise to repay, plus interest) and a liability (a new deposit in your account, spendable at once). No other customer's balance falls by a penny. Money has been created: not printed, typed. The process runs in reverse too: when you repay principal, the deposit and the loan extinguish each other, and that money ceases to exist. Broad money is therefore elastic. It expands when banks lend faster than borrowers repay and contracts when repayment outruns new credit. That is precisely what makes credit crunches so vicious.

So what stops a bank lending infinitely? Not reserves. The UK abolished binding reserve requirements decades ago, and even where they exist central banks supply reserves on demand at a price; as the New York Fed's Alan Holmes admitted back in 1969, banks lend first and look for the reserves later. The real constraints are commercial and regulatory: profitability (will this loan pay, at the current Bank Rate, after funding costs and defaults?), capital requirements under the Basel rules (shareholders' own funds must be thick enough to absorb losses), borrower demand (someone creditworthy must want the loan), and the policy rate itself. The system has a throttle and a brake. It does not have a fuel gauge.

Why it matters: if loans create money, then the money supply is driven by private lending decisions, and most new money enters the economy as mortgage credit, bidding up the price of houses that already exist. New money is not sprinkled evenly; it arrives somewhere first, and whoever is nearest the tap benefits before prices adjust. That is the Cantillon effect, three centuries old and still on duty. It also means boom and bust are built into the credit machine, not bolted on: expansion needs no printing press, only optimism and collateral. Use the balance-sheet simulator below: make a loan, watch both sides of the ledger grow, repay it, and watch the money vanish.