How Banks Create Money

Yes. You heard that right! Banks create money. No, they don't have smoke-filled basement rooms in which counterfeiters work vigorously. Banks don't make currency as in notes and coins, what they create is deposits, and they do so by making loans.

Now banks are not magicians either. They can't create money out of thin air. In order to create money, they need a raw material - money. This money comes from customers' deposits. It is the money we deposit into the banks.

Armed with these deposits as reserves, banks can now make loans. Note that banks don't have $100 of reserves for every $100 that customers have deposited with them. If banks behave this way, they wouldn't earn any profit. Banks loan out more money than the reserves they possess, thus in the process, banks create new money that did not exist before.


Bank's required reserve ratio determines the maximum amount of loans that banks can make. Banks are required to hold a level of reserves that does not fall below a specified percentage of total deposits. This percentage is the required reserve ratio.

The required reserve ratio is a bank regulation set by the central bank. It normally ranges from 3-10%. A 3% reserve ratio means that the banks must keep $3 for every $100 deposits, and can loan the remaining $97. A 10% reserve ratio means the banks have reserves of $10 for every $100 while the rest $90 can be loaned out. These reserve levels, albeit low, are adequate for ordinary business needs.

To illustrate this, let's assume the required reserve ratio is 10%.

One day, Roger deposits $100,000 into a certificate of deposit at Citibank. Now Citibank can use this money to create loans. With a required reserve ratio of 10%, Citibank can loan out a maximum amount of $90,000 and keep only $10,000 as reserves. On the second day, Andy approaches Citibank for a loan of $90,000. The bank manager approves the loan and opens an account for him with a credit balance of $90,000.

The story does not end there. According to Citibank's balance sheet, the $90,000 loan to Andy is also a $90,000 asset for the bank. Andy has to repay the $90,000 (plus interest) to Citibank at a future date. As you can see here, Citibank has effectively created $90,000 out of nothing.

Since Citibank has now an additional $90,000 asset, it can make another loan based on this asset. Hence, a second $81,000 loan is created.

This process will keep on repeating itself. Loan #3 is $72,900, loan #4 $65,610 and so on and so forth. A initial deposit of $100,000 will eventually create $1,000,000 of money (the original $100,000 deposit and another $900,000 loan).

Now you should see that banks only have tiny amount of reserves, reserves that are needed to meet depositors' demand for currency and to make payments to its creditors. When confidence towards a bank falters, a bank run occurs. And this is what happened to many US banks in the current crisis - Huge bets on CDO and other derivatives turned sour, confidence eroded, followed by large withdrawals from their depositors. The banks failed when they couldn't repay all their creditors and depositors at once.