Where does money come from? Many people might answer without hesitation that it comes from the printing press, but the reality is different from most people’s intuition: besides the output of the printing press, when banks issue loans, they create new deposits in the borrower’s account, as well as a new liability, thus creating new money in the economy. This may sound counterintuitive: do banks create money out of thin air? Is money created by banks rather than printed by the printing press? Can loans be issued without money? In today's Market Watch, we will help you understand the nature of money and loans:

Summary

• Money can be divided into two types: currency and deposits. Currency refers to paper notes and coins issued by the government or the central bank, which have legal status and can be used to pay debts by force; deposits refer to digital money created by commercial banks, which flow between accounts through transfers or checks, and may not have physical currency backing them.
• When banks issue loans, they do not transfer existing deposits to the borrower, but increase the corresponding amount of deposits in the borrower’s account, while recording an equal amount of loans on their balance sheet. This means that banks create new deposits, or new money, through loans.
• The deposits created by banks must be offset by an equal amount of loans, so banks cannot create money without limit. The money created by banks is also subject to regulation and control by the central bank, such as reserve ratio, interest rate and other policies.

Money in modern economies

First of all, we need to understand what “money” is. In economics, money has three basic functions: medium of exchange, unit of account and store of value. Medium of exchange refers to something that can be used to exchange goods and services; unit of account refers to a unit that can be used to measure the value of goods and services; store of value refers to something that can be used to preserve purchasing power.

According to these functions, we can divide money into two types: currency and deposits. Currency refers to paper notes and coins issued by the government or the central bank, which have legal status and can be used to pay debts by force; deposits refer to digital money created by commercial banks, which flow between accounts through transfers or checks, and may not have physical currency backing them.

Loans play a very important role in the process of “creating” money: lenders are usually commercial banks/central banks, while borrowers can be governments, businesses or individuals. When banks issue loans, they do not transfer existing deposits to the borrower, but increase the corresponding amount of deposits in the borrower’s account, while recording an equal amount of loans on their balance sheet. This means that banks create new deposits, or new money, through loans.

Many people may have heard of the concepts of M0, M1 and M2, which are three definitions of money supply. Generally speaking

• M0 = cash in circulation, which is paper notes and coins held by the public, is the most liquid form of money, existing as non-bank deposits.
• M1 = M0 + commercial bank demand deposits, is narrow money supply, reflecting the real purchasing power in the economy.
• M2 = M1 + commercial bank time deposits, is broad money supply, reflecting the potential purchasing power in the economy.

Different economies have slightly different definitions for M0，M1 and M2，but from a general perspective their use is similar: measuring the circulation of monetary assets at a specific time. In modern economies，most of the money exists as deposits.

A simple example

Suppose there is a bank called A Bank，which accepts a customer’s 100 dollars cash deposit. According to the central bank’s regulations，A Bank must maintain a 10% reserve ratio，which means that it must deposit 10 dollars in the central bank，as a reserve for withdrawal demand. The remaining 90 dollars，A Bank can use it to issue loans，earn interest income.

Suppose A Bank lends this 90 dollars to a customer，who uses it to buy a piece of clothing.The clothing store deposits this 90 dollars into another bank B Bank. B Bank also has to maintain a 10% reserve ratio，9 dollars deposited in the central bank，the remaining 81 dollars can be used for lending. This process can be repeated indefinitely.

In this example，the original cash is 100 dollars，the reserve ratio is 10%，therefore：100 × (1 / 0.1) = 1000 That is to say，the total amount of money in the economic system can theoretically increase to 1000 dollars. Of which 100 dollars is cash，900 dollars is deposits. This 900 dollars is the digital money (deposits) created by the bank through loans.

Do banks create money out of thin air?

Therefore，the source of money in the economy has two main types: one is the currency issued by the central bank; the other is the deposits created by commercial banks.

The currency issued by the central bank is the most basic form of money，and also the reserve of commercial banks. The central bank can increase or decrease the amount of currency by buying and selling government bonds or other assets，or by directly providing funds to the government or commercial banks. The currency issued by the central bank，also known as base money，M0 is part of it，M0 is like commercial bank deposits in the central bank，which are numbers on the central bank account，they can be used for settlement or payment of central bank interest and so on.

The deposits created by commercial banks are the most important form of money: banks do not create money out of thin air，but create deposits digital money through loans. This digital money is based on the credit of banks and the support of the central bank，it is not real currency，but a means of payment. The deposits created by banks must be offset by an equal amount of loans，so banks cannot create money without limit. The money created by banks is also subject to regulation and control by the central bank，such as reserve ratio，interest rate and other policies.

Using the example of banks to explain:

One of the conditions for banks to create money is to have sufficient reserves. Reserves are cash that banks keep in the central bank or their own vaults，to cope with customer withdrawal demand or other emergencies. The central bank usually requires banks to maintain a certain proportion of reserve ratio，which means that banks must keep a certain proportion of deposits as reserves，and cannot use them for loans，thus theoretically limiting the amount of money that banks can create，the higher the reserve ratio requirement，the lower this limit.

Another condition for banks to create money is to have sufficient credit. Credit refers to the trust relationship between banks and customers，as well as between banks and the central bank. If banks do not have credit，then customers will not deposit money in banks，nor will they accept loans from banks; similarly，if the central bank does not have credit，then banks will not accept currency issued by the central bank，nor will they comply with the central bank’s regulations.

The central bank as the executor of monetary policy，can influence commercial banks’ lending capacity and “money creation” speed through setting interest rates，buying and selling assets，adjusting reserve ratio and other means.

Thinking logic - from the perspective of balance sheet

Do loans create deposits or do deposits create loans? This question is similar to whether chickens lay eggs or eggs hatch chickens，this is a complex process involving multiple subjects and links，and cannot be summarised with a simple argument，but we can imagine it as a circular process.

For the concept of “banks create money”，we need to look at it from the perspective of balance sheet，otherwise this sentence will sound illogical. At the same time as creating money, liabilities increase correspondingly, so there is no creation out of thin air.

Similarly, when China’s recovery was below expectations, some views mentioned that China’s deposits increased by 78 trillion yuan in 2022, and that an increase in deposits should indicate that people have more money available for consumption, so why is consumption still far below expectations? Is there a contradiction?

From a balance sheet perspective, it can be explained that although total deposits increased significantly, but debt leverage ratio also increased significantly.

From the above figure, we can observe that China’s total deposit trend and household debt total trend are almost identical, to some extent we can directly observe how commercial banks create deposits through loans, and thus create “money”.

Understanding loans and wealth preservation

In a previous article Lombard Loan we introduced a common loan tool for private banking: Lombard Loan As a collateralised loan tool, Lombard Loan has become a popular financial tool that allows borrowers to fully leverage their eligible collateral value. Financial institutions, usually private banks, provide liquidity based on collateral provided by borrowers, including securities, bonds, insurance or other liquid assets. By providing collateral, borrowers reduce risk, creating a win-win situation for both parties. This is also a direct case of how banks create money in the economy.

In addition, on April 14, 2022, American entrepreneur Elon Musk proposed to acquire social media company Twitter for $43 billion, and eventually completed the acquisition at a price of $44 billion. Initially Elon Musk had plans not to sell his Tesla stock, hoping to obtain liquidity through a single stock pledge.

But in the end he sold about $15.5 billion worth of Tesla stock in two waves in April and August. In addition to the support of some investment funds, about $13 billion was provided by bank loans. Elon Musk created new deposits, or credit money, by borrowing from banks. These deposits can be used to pay Twitter shareholders or buy other assets, thereby increasing liquidity and effective demand in the economy to some extent.

Investment Ideas and Suggestions

Investors can make full use of private banking loan tools through appropriate tools, activate existing assets. For example, investors can use illiquid assets (such as stocks, funds, art, etc.) as collateral, apply for loans from private banks, and then use the loans to buy assets with dividends or yields (such as bonds, etc.). In this way, investors not only retain the original asset rights and interests, but also obtain an additional source of income.

In addition, investors can also use loans to achieve other investment goals, such as buying real estate, acquiring other companies, etc. The advantage of this investment strategy is that it improves the utilization rate of funds, reduces the idle cost of funds, and also increases the diversification and flexibility of investment. Of course investors also need to pay attention to the risks and costs of loans, such as interest rate changes, collateral value fluctuations, repayment ability, etc. Therefore investors should make reasonable judgments and plans according to their own risk preferences, financial situation and investment objectives when choosing loan tools.