Whose Money Is the Bank Lending?
Most people believe banks lend the deposits of other customers. In reality, modern commercial banks create new deposit money when they extend credit.
Whose Money Is the Bank Lending?
8 Minutes
Intermediate
✓ Lesson 1
Lesson 2 of 3
Lesson Concepts Covered
Commercial bank lending
Money creation
Deposit creation
Bank reserves
Banking risk
If banks don't simply lend someone else's deposits, whose money are they lending when they approve your loan?
Part 1 • The Common Misconception
When you go out to take a loan from the bank, whose money are they lending? Are you getting money that they have sitting inside the vault?
Most people answer yes.
Banks lend the money deposited by other customers.
When a bank approves a loan, it simultaneously creates a brand-new bank deposit that did not previously exist.
Whose Money Is Being Lent?
You are creating new money. Lending creates money out of nothing, and that money is deposited somewhere, creating deposits.
"If two parties, instead of being a bank and an individual, were an individual and an individual, they could not inflate the circulating medium by a loan transaction, for the simple reason that the lender could not lend what he didn't have, as banks can do. Only commercial banks and trust companies can lend money that they manufacture by lending it."
— Irving Fisher
Fisher emphasized that commercial banks possess a unique legal ability unavailable to ordinary individuals: the ability to create new deposit money through lending.
See Bank Credit Creation Yourself
If banks don't simply lend someone else's deposits, whose money are they lending when they approve your loan?
Launch the Bank Credit Simulator →Deposits, Counterparty Risk & Banking Stability
Understanding that bank deposits are loans to the bank changes how we should think about the safety of our money.
Every financial contract depends upon the ability of the other party to fulfill its promise. Economists refer to this as counterparty risk.
When you hold a bank deposit, the bank is your counterparty. Your account balance represents the bank's promise to repay you on demand. As long as the bank remains financially sound, that promise is generally honored without question.
"Every financial contract depends on the strength of the counterparty. If the party guaranteeing payment weakens, the value of that guarantee weakens as well."
— Interview Guest
Why Counterparty Risk Matters
Under normal economic conditions, depositors rarely think about the financial health of their bank because withdrawals occur smoothly and confidence remains high.
Problems arise when confidence begins to disappear. If enough depositors question whether a bank can honor its obligations, many may attempt to withdraw their funds simultaneously.
This phenomenon is known as a bank run.
Why Deposit Insurance Exists
Deposit insurance was created to reduce the likelihood of bank runs by reassuring depositors that their money would be protected even if an individual bank experienced financial difficulty.
Whether deposit insurance completely eliminates counterparty risk is a separate question. What it demonstrates is that governments recognize the importance of maintaining confidence in the banking system.
Key Takeaways
A bank deposit is a promise made by a financial institution.
Every promise carries counterparty risk.
Confidence plays a critical role in maintaining banking stability.
Deposit insurance was introduced to reduce panic and help prevent bank runs.
Understanding counterparty risk is essential to understanding modern banking.
Banks Create Deposits Through Lending
Commercial banks generally do not lend existing deposits. When a bank approves a loan, it simultaneously creates a brand-new bank deposit that did not previously exist.
What Happens When Depositors Stop Bearing the Risk?
Deposit insurance was created to reduce panic and help prevent bank runs. But protecting depositors from losses introduces another important question: can protection against risk change the behavior of the institutions taking that risk?
NEXTLast edited by MoneyMan
