That's not quite correct. If you apply for a $10k loan from a bank then, once the loan is approved, the bank will simultaneously:
- increase your current account balance by $10k (credit your current account)
- increase your loan account balance by $10k (debit your loan account)
That $10k deposit appeared from nowhere. You didn't 'put the deposit in', and it wasn't transferred from another customer or another bank. And the bank does not need to have $10k sourced from somewhere else.
Of course, when you want to withdraw that that $10k, or transfer it to someone who uses a different bank, the bank will have to come up with $10k from somewhere.
But maybe whatever they are called up to transfer to customers of other banks will be balanced out by transfers from other banks' customers to their own.
> If you apply for a $10k loan from a bank then, once the loan is approved, the bank will simultaneously:
- increase your current account balance by $10k (credit your current account)
- increase your loan account balance by $10k (debit your loan account)
That $10k deposit appeared from nowhere. You didn't 'put the deposit in', and it wasn't transferred from another customer or another bank. And the bank does not need to have $10k sourced from somewhere else.
This is not correct. A bank lends against its cash assets, not against nothing.
Bank accounting works like so: when you deposit $1 at the bank, the bank’s assets increase by $1 (the $1 you just gave it), and its liabilities also increase by $1 (the bank owes you your dollar back when you want it). A bank’s loans are financed by its assets; each dollar it lends is a dollar taken from the asset side of its balance sheet. When a bank lends you $1, it (1) decrements its asset balance by $1, (2) increments your bank account by $1, (3) creates a new asset representing a $1 loan on its own balance sheet, and (4) creates a new liability for you representing a loan of $1 owed.
Point is, a bank does not create money from absolutely nothing when making loans in the way you describe. All loans are financed by the bank’s assets, and a bank cannot originate a larger value of loans than the value of its cash assets. Bank “money-creation” refers to the fact that the total bank account balances in the economy increase when a bank makes a loan; this happens after what I described in the previous paragraph, since the $1 loan now increments your bank account, while nobody else’s bank account balance decreases.
(To see how this works in more detail, imagine the process begins with Alice depositing a one-dollar bill at the bank, and then the bank loaning Bob one dollar. Keep track of the distinction between who has the one-dollar bill and who has a one-dollar bank account balance. The loan proceeds as follows: first the bank gives Bob the one-dollar bill it took from Alice as a deposit, then Bob turns right around and deposits the one-dollar bill back at the bank. The result is that Alice and Bob now both have $1 bank account balances after the loan is made, whereas only Alice did before; the bank still has the one-dollar bill. Summing either bank account balances alone or balances plus dollar bills shows $1 more after the loan was made.)
I remember the Khan Academy course on banking to be useful for understanding what's going on. There's a lot more to it now, and it's closer to the "out of thin air" view these days.
I am having difficulty following your explanation. You described 4 accounting entries:
1. Credit asset account X (which one?)
2. Credit customer's bank account
3. Debit customer's loan account
4. Debit liability account Y
I agree with #2 and #3, which I described in my earlier comment. But:
#4 is already handled by #3
#1 is some unspecified 'asset' account; which one? It can't be cash (as they're not paying out cash) and it can't be a balance they hold with another party (as nothing in this transaction involved anyone but the customer and the bank)
Please take another look. Maybe defining which exact asset and/or liability accounts you believe are affected by each of the entries #1 to #4 will help me understand your point better.
Sorry, re-reading my comment I can see that it is likely only to add to the confusion. (The downvotes suggest so also! Apologies all around.)
I meant to make two points. First, that IMO it is misleading to say that a bank simply creates new money ex nihilo when making a loan, counter to what you wrote ("the bank does not need to have $10k sourced from somewhere else"). There is in fact a bound on the amount of new lending a bank can undertake, one related to its assets, and in that sense the money lent does "come from somewhere." My attempt at a (poorly) stylized accounting was meant to illustrate what sort of thing makes up a bank's cash assets and how they relate to lending, but I'll try a new approach below. Second, I was trying to clarify what "bank money" means, to explain how it gets created, as much of the broader confusion in this thread seems to be around what "[bank] money-creation" really entails.
Let me try to make my first point again. In modern banking systems, fractional reserve has been mostly replaced by capital requirements, which limit a bank to holding an amount of (risk-weighted) assets no greater than some multiple of its capital. A bank's capital is its assets less its liabilities, which we'll write A - L. Let's call the regulatory capital multiple M, then capital requirements essentially say that A <= M(A - L). When a bank makes a new loan, its assets and liabilities increase equally in the way you described. That means that for a loan of X, if the lending bank is not already bounded by capital requirements, that the capital adequacy inequality becomes X + A < M(A + X - (L + X)) = M(A - L). That is, the left side of the inequality increases but the right side of the inequality is unchanged, so the capital requirement binds more tightly. In particular, it must be that the loan amount X < M(A - L) - A; in other words, new loans are constrained to be less than the excess of regulatory capital over pre-existing assets. So a bank cannot just create arbitrarily large new loans; loans are constrained by capital, the positive component of which is assets. That's where loan money "comes from": a bank's assets.
The second point I meant to make about bank money-creation was not directed at your comment specifically. But I wanted to point out that "bank money" simply means the sum of all bank deposits, and that it, too, is constrained to be a finite number. In this sense also banks cannot poof into existence arbitrarily large loans (with corresponding deposits) in the way I read your comment to imply.
> The obvious next question is: what, if any, mechanism
> puts a limit on bank X's ability to lend? If it
> considers a borrower credit-worthy for a $1 billion
> unsecured loan, can it just make the loan, even if the
> loan is much larger than the bank's existing balance
> sheet? What will happen when the borrower tries to spend
> some of the money with a customers of bank Y or Z?
The answer is, of course, the capitalization requirements you described above mean that (i) no, it can't make arbitrarily large loans, and (ii) the bank should hopefully have enough liquid assets to satisfy redemption of demand deposits.
- increase your current account balance by $10k (credit your current account)
- increase your loan account balance by $10k (debit your loan account)
That $10k deposit appeared from nowhere. You didn't 'put the deposit in', and it wasn't transferred from another customer or another bank. And the bank does not need to have $10k sourced from somewhere else.
Of course, when you want to withdraw that that $10k, or transfer it to someone who uses a different bank, the bank will have to come up with $10k from somewhere.
But maybe whatever they are called up to transfer to customers of other banks will be balanced out by transfers from other banks' customers to their own.