When a bank lends $10 million, it adds $10 million to the borrower's account. In our made-up economy, total deposits rise from $180 million to $190 million, while no saver's money moves.
Two made-up banks, Alpha and Beta, show how this works. Alpha makes the loan. Beta receives the payment when the borrower spends it. We then compare the result with the money multiplier model, a textbook account in which banks lend out deposits they have already received.
How do banks create money? A bank creates money when it makes a loan. It credits the borrower's account with a new deposit. That deposit is new money.
In our example, a bank called Alpha made a $10 million loan. Total deposits rose from $180 million to $190 million. Alpha did not need to lend out any existing deposit.
The money stays in the economy when the borrower spends it. Repaying a loan removes it.
Three things limit how much money banks create: the cost of finding funds, the owners' capital and loan repayments, which remove money.
What counts as money in a bank's accounts?
In this article, money means the deposits that households and firms hold at banks. A deposit is what the bank owes its customer. Accountants call that a liability.
A loan is what a borrower owes the bank. Accountants call that an asset.
Reserves are the balances a bank holds at the central bank. Banks use reserves to settle payments with each other. Equity is the owners' stake, which is the bank's assets minus what it owes depositors.
Our example has two banks. Each starts with $20 million of reserves and $80 million of loans. Each owes depositors $90 million and holds $10 million of equity. Together the two banks hold $180 million of deposits, which is all the money in the example.
How does a bank loan create a deposit?
Alpha approves a $10 million mortgage for Maria. Alpha does not hand her banknotes. It adds $10 million to her account and records $10 million more of loans.
Alpha's loans rise from $80 million to $90 million. Its deposits rise from $90 million to $100 million. Its reserves stay at $20 million, while its equity stays at $10 million.
Chart 1 shows Alpha's side. Its loans and deposits each rise by $10 million, while reserves and equity stay the same.
Source: YX Insights calculation
Across both banks, total deposits rise from $180 million to $190 million. No depositor gave up anything to fund the loan. Alpha's other customers still hold $90 million. Beta's customers still hold $90 million.
The table gives both banks at each step of the example.
Step | Alpha: reserves / loans / deposits | Beta: reserves / loans / deposits | Total deposits |
|---|---|---|---|
Start | $20 / 80 / 90 million | $20 / 80 / 90 million | $180 million |
Alpha lends $10 million to Maria | $20 / 90 / 100 million | $20 / 80 / 90 million | $190 million |
Maria pays Sam, who banks with Beta | $10 / 90 / 90 million | $30 / 80 / 100 million | $190 million |
Branch: Sam repays a $10 million loan at Beta | $10 / 90 / 90 million | $30 / 70 / 90 million | $180 million |
Both banks hold $10 million of equity at every step. The last row branches from the third row. Source: YX Insights calculation
What happens when the borrower spends the money?
Maria buys a flat from Sam, who banks with Beta. She pays $10 million. Her deposit at Alpha falls by $10 million, while Sam's deposit at Beta rises by $10 million.
Alpha settles with Beta by sending $10 million of reserves. Alpha ends with $10 million of reserves and $90 million of deposits. Beta ends with $30 million of reserves and $100 million of deposits.
Total deposits stay at $190 million. The new money passed from Maria to Sam, while only the reserves moved between the banks.
Do banks lend out the money savers deposit?
No. When Alpha lent to Maria, the $90 million held by its other customers did not change. The loan added a new deposit. It did not move an existing one.
Reserves are not the source of the loan either. Alpha's reserves stayed at $20 million through the loan. They fell only when Maria's payment went to a customer of another bank.
In the example, the loan and the deposit appear together. No saver had to deposit first.
How does the money multiplier model work?
The money multiplier model runs in the opposite order. It starts with a deposit. The bank keeps a required share as reserves and lends the rest. The borrower spends the loan. The seller deposits it at a bank, which repeats the steps.
A reserve requirement is the share of deposits a bank must hold as reserves. Take a first deposit of $200 million and a reserve requirement of 10%. The first bank keeps $20 million and lends $180 million. Each round of lending is 90% of the one before.
Total deposits then approach $200 million divided by 0.10, which is $2,000 million. Chart 2 shows the total after the 1st, 2nd, 3rd, 5th, 10th and 20th deposit.
Source: YX Insights calculation
After ten deposits, total deposits are $1,303 million. After 20 they are $1,757 million.
In our ledger, the loan came before any new deposit arrived. The model assumes the opposite order, so it does not describe how Alpha created its deposit.
The Federal Reserve Board cut every US reserve requirement ratio to 0% on 26 March 2020. Before the cut, the highest ratio was 10%.
At 0%, the formula divides $200 million by zero and gives no answer. The requirement therefore cannot be what limits lending.
What limits how much money banks create?
Three things limit it in our example. The first is the cost of funding.
Suppose Alpha lends $10 million a round and each borrower pays a customer of Beta, while Beta lends nothing. Each loan pulls $10 million of reserves out of Alpha. Reserves reach $0 after two loans. After four loans Alpha is $20 million short.
Alpha must then borrow that sum, or pay savers more to attract deposits. Either costs interest.
In a second case, Beta lends the same amounts. Its borrowers pay Alpha's customers, so the payments offset.
Source: YX Insights calculation
Chart 3 shows Alpha's reserves falling to negative $20 million when only Alpha lends. They stay at $20 million when both banks lend. In the second case, total deposits reach $260 million after four rounds.
The second limit is capital. Equity absorbs losses. Suppose a made-up rule says equity must be at least 8% of loans. Alpha's $10 million of equity then supports loans of up to $125 million.
Alpha starts with $80 million of loans, so it has room for four more loans of $10 million. At $120 million of loans, equity is 8.3% of loans. A fifth loan takes loans to $130 million and equity to 7.7%, below the rule.
The third limit is repayment. Suppose Sam uses his $10 million to repay a $10 million loan that he owes Beta.
Beta's loans fall to $70 million, while its deposits fall to $90 million. Total deposits return to $180 million. The money that Alpha created is gone.
What does this example leave out?
The example uses two banks and round numbers. It counts only bank deposits as money. In the United Kingdom, bank deposits made up 97% of broad money (the total stock of money) in December 2013, according to the Bank of England.
The example also leaves out interest, loan losses and the central bank's interest rate, which sets the price of reserves. Central banks can also add deposits by buying bonds, as our explainer on Quantitative Easing shows.
Where can I read more about how banks create money?
The mechanism follows the Bank of England's 2014 Quarterly Bulletin article, "Money creation in the modern economy". The reserve requirement dates come from the Federal Reserve Board. We read both sources on 28 October 2026.
Whether more money raises prices is covered in our explainer on money printing and inflation. The broad measure that counts deposits is covered in what M2 money supply is. Our explainer on what the Fed does covers the central bank behind the reserves.
A bank creates money when it lends. In our example, the money lasted until a repayment removed it.
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Common questions about how banks create money
Do banks create money out of thin air?
Not from nothing. A new deposit comes with a new loan of the same size, so the bank also gains a claim on the borrower. In our example, Alpha's $10 million loan created a $10 million deposit for Maria and a $10 million claim on her.
Does repaying a loan destroy money?
Yes. A repayment removes a deposit and a loan together. In our example, Sam used $10 million to repay a loan he owed Beta. Beta's loans and deposits both fell by $10 million, so total deposits returned from $190 million to $180 million.
What is the money multiplier?
The money multiplier is the ratio of total deposits to the first deposit when banks lend all they are allowed to. With a 10% reserve requirement it is 10, so a $200 million first deposit approaches $2,000 million. The model starts with a deposit, while our ledger starts with a loan.
Can a bank create unlimited money?
No. Three things limit it: what funding costs, how much capital the bank holds and how fast borrowers repay. Capital is the owners' stake in the bank. In our example, a made-up rule that equity must be at least 8% of loans let Alpha make four more $10 million loans, but no fifth.
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