How banks create money
Most of the money in existence was created by commercial banks making loans. This is not a conspiracy theory; it is how the system is documented to work.
The intuitive picture is that banks collect deposits from savers and lend them to borrowers. It is a reasonable description of a pawnbroker. It is not how a modern bank works, and the difference matters for understanding interest rates, credit cycles and inflation.
What actually happens
When a bank grants a $200,000 mortgage, it does not move $200,000 from someone else's account. It writes two entries: a $200,000 asset (your obligation to repay) and a $200,000 liability (the balance now in your account). Both sides appear simultaneously and neither existed a moment earlier. The money supply just increased by $200,000.
This is not a fringe account. It is how central banks themselves describe the mechanism in their own published explanations of monetary policy.
The old story, and why it is wrong
Textbooks long taught the money multiplier: banks receive deposits, keep a fraction in reserve, lend the rest, which is redeposited, and so on. The arithmetic is elegant and the causation is backwards.
Banks do not check their reserve balance before making a loan. They lend when they find a creditworthy borrower at a profitable rate, and obtain whatever reserves settlement requires afterwards — from other banks or from the central bank. Several jurisdictions have abolished reserve requirements entirely without any effect on this process, which would be inexplicable if the multiplier story were correct.
What actually constrains lending
- Creditworthy demand. Banks need borrowers who want to borrow and are likely to repay. In a downturn, this constraint binds hard — which is why cutting rates is a weak tool in a slump.
- Capital. Regulation requires equity against assets. A bank can only expand its loan book so far on a given capital base, which is the binding constraint in practice.
- Profitability. The spread between lending and funding costs has to justify the risk.
- Central bank policy rate. The price of the reserves banks need for settlement, which sets the floor under lending rates.
Destruction, too
The reverse is symmetrical and less discussed. When you repay a loan, the deposit and the debt cancel and the money ceases to exist. In a period where repayments exceed new lending, the money supply contracts without anyone deciding it should.
Why this matters to an investor
It explains why credit conditions — not just policy rates — drive the credit cycle. It explains why central banks can create reserves in enormous quantity through quantitative easing without those reserves becoming spendable money in the economy, since reserves circulate only between banks. And it explains why bank lending data is among the more useful leading indicators available.