How banks create money

Ask most people where money comes from and they will point to the Royal Mint or the printing presses at the Bank of England. Yet notes and coins make up only a small slice of the money in the economy. The overwhelming majority is digital — the balances sitting in current and savings accounts. And those balances are created not by the state but by ordinary commercial banks, in the act of making loans. Understanding this changes how you think about credit, central banks and financial crises.

Money is mostly bank deposits

When economists talk about “the money supply” they mean far more than cash. In the United Kingdom, physical currency accounts for only a few per cent of the broad money stock. The rest is made up of deposits: the figures in your bank account that you can spend by card, transfer or standing order. A deposit is simply a record that your bank owes you money and promises to pay it on demand. For most purposes that promise works exactly like cash, which is why we treat deposits as money.

This matters because it means the quantity of money in circulation depends heavily on the behaviour of private banks, not just on decisions taken by the government or the central bank. To see why, you have to look at what actually happens when a bank lends.

Loans create deposits

The intuitive story is that a bank gathers up savers’ deposits and lends them on to borrowers, acting as a middleman. That picture is misleading. As the Bank of England explained in its widely cited 2014 article “Money creation in the modern economy”, banks do not lend out pre-existing money. When a bank grants a loan, it credits the borrower’s account with a brand-new deposit. At a stroke the bank acquires an asset — the loan, which the borrower must repay — and a matching liability — the deposit it has just created. That deposit is new money that did not exist a moment before.

In other words, loans create deposits, not the other way around. When you take out a mortgage, the bank does not raid a vault of savers’ cash; it types a new balance into your account. The same logic runs in reverse when loans are repaid: paying back a loan extinguishes the deposit used to make the payment, and money disappears from the economy. The total stock of money therefore expands when banks lend faster than borrowers repay, and contracts when the reverse happens.

The old money-multiplier story

For decades textbooks taught a different mechanism, known as the money multiplier. In this account the central bank decides how much “base money” (reserves) to create. Banks must hold a fixed fraction of their deposits as reserves and lend out the rest. The money that is lent gets re-deposited, allowing further lending, and so on. Through this chain an initial injection of reserves multiplies up into a much larger quantity of deposits. The appealing implication is that the central bank controls the money supply directly by controlling reserves.

The trouble is that this is not how banking actually works in a modern system. Banks do not wait for reserves before lending. They make loans when they see profitable, creditworthy opportunities, creating deposits in the process, and then acquire whatever reserves they need afterwards — borrowing them from other banks or from the central bank. Causation runs the opposite way to the textbook: lending decisions come first, reserves follow.

The modern endogenous view

The contemporary view is that money is largely “endogenous”: its quantity is determined from within the economy by the demand for credit and banks’ willingness to supply it, rather than imposed from outside by the central bank. This does not mean creation is unlimited. Banks are disciplined by several forces: loans must be repaid, so reckless lending threatens profits; they compete for sound borrowers; and they must meet capital and liquidity regulations designed to keep them safe. Above all, monetary policy bites. By setting Bank Rate — the interest it pays on reserves — the Bank of England influences the rates banks charge on loans. Raise rates and fewer loans are demanded and granted, slowing money creation; cut them and credit expands.

So the central bank steers the system mainly through the price of money rather than a fixed quantity of it. Quantitative easing, in which the Bank creates new reserves to buy government bonds, is a separate tool used when Bank Rate is already very low; it adds reserves and can lift broad money, but it is distinct from everyday creation through lending.

Why it matters

Recognising that private banks create most money reframes several big debates. It links the money supply to credit cycles: booms are periods of rapid deposit creation, busts periods of contraction, as Mervyn King discusses in The End of Alchemy. It clarifies how monetary policy works — through influencing lending, not mechanically multiplying reserves. And it underpins arguments about financial stability and regulation, including more radical proposals to change who is allowed to create money in the first place. Far from being a dry technicality, the question of where money comes from sits at the heart of how a modern economy behaves.