Bank A
| Assets | Liabilities + equity | ||
|---|---|---|---|
| reserves | 100 | deposits | 300 |
| loans | 200 | borrowing | 0 |
| bonds | 40 | equity | 40 |
| Total | 340 | Total | 340 |
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Monetary systems · Lesson 3
How a bank loan creates a deposit
Follow origination without confusing money creation with free resources.
By the end: Write the bank and borrower entries and explain why they do not imply unlimited lending.
Origination is a paired promise
A bank approves a loan of 60 and credits the borrower's account. On the bank's balance sheet, loans rise by 60 and deposit liabilities rise by 60. On the borrower's books, the deposit asset rises by 60 and loan debt rises by 60. No existing depositor needs to lose a deposit in this transaction. The bank has created a new transferable claim on itself in exchange for the borrower's promise.
The loan is an asset to the bank because the borrower owes repayment. It is not bank profit of 60. The deposit is an equal new obligation. Ignoring origination fees, expected-loss provisions, and costs in this teaching entry, bank equity is unchanged. Real banks may recognize expected credit losses immediately; then equity can fall even at origination.
Write both sides of the new contract
A bank loan begins with an agreement about principal, repayment dates, interest, and other conditions. Principal is the amount borrowed before interest and fees. In the simplified origination entry, the bank accepts a claim on the borrower and issues a deposit claim the borrower can use for payments. These are different promises with different issuers. The borrower promises to repay the loan. The bank promises to honor the deposit under its account terms. Calling both entries money would conceal the distinction between loan assets and monetary liabilities.
Follow the fixed opening numbers used in the worked model. Bank A holds reserves of 100, loans of 200, and bonds of 40. Its assets total 340. It owes deposits of 300, has no other borrowing, and has equity of 40. Adding deposits and equity also gives 340. Bank B starts with exactly the same balances. Together they have deposits of 600 and reserves of 200 before the modeled loan. These are existing stocks, not amounts created by the demonstration.
When A grants 60, first increase its loan asset from 200 to 260. Next increase its deposit liability from 300 to 360. Reserves stay 100 and bonds stay 40, so assets now total 400. Deposits of 360 plus equity of 40 also total 400. The rise in assets is matched by a rise in obligations, not an increase in bank earnings. The bank cannot count the borrower's promise as profit while ignoring the deposit it has promised to honor.
The borrower's separate entry contains a deposit asset of 60 and a loan liability of 60. If those are its only financial balances, subtracting the loan from the deposit gives zero net financial wealth at origination. The borrower nevertheless gains access to a payment asset and can make a purchase it could not previously fund. That gain in liquidity is useful. It does not erase the repayment obligation or guarantee that the purchased asset or business activity will cover the debt.
No saver loses 60 from an account in this entry. That is the precise sense in which the loan creates a deposit rather than merely reallocating an existing deposit. The bank's opening reserves also do not fall by 60 at origination. Reserves and customer deposits belong to different holders on different ledgers. A can increase what it owes its customer while leaving its existing central-bank account unchanged. A later external payment introduces a separate requirement to obtain or transfer settlement assets.
Actual origination may include fees and recognition of expected credit losses. A provision for expected loss records an allowance against asset value before a final default is known. Its expense can reduce earnings and equity. The worked model omits those entries so the loan and deposit increase equally and equity remains fixed. This is a stated simplification, not evidence that banks can make loans without operating costs, credit risk, or capital consequences. The entries establish the initial accounting mechanism under the specified assumptions.
Creation is not settlement
No reserves move merely because the bank credits an account on its own ledger. If the borrower spends to a customer of another bank, the originating bank normally needs settlement assets or credit to complete that external payment. A loan can therefore create deposits without first receiving a matching deposit, while still exposing the bank to funding and liquidity needs.
The familiar money-multiplier story assumes a fixed reserve supply, a binding reserve ratio, and repeated lending of the maximum permitted amount. Under those assumptions a mathematical upper bound can be calculated. It is not a general causal description of lending in modern interest-rate operating systems. Borrower demand, credit risk, capital, funding costs, and regulation cannot be replaced by a mechanical multiplication of reserves.
Distinguish the first entry from the payment it enables
In the model's loan-and-payment sequence, the borrower then pays 60 to a customer of B. A reduces its deposit liabilities from 360 to 300. It also transfers 60 reserves, reducing its reserve asset from 100 to 40. Loans remain 260 and bonds remain 40, so A's assets are now 340. The new loan remains on A's books even though the newly credited deposit no longer does. A's obligation to the borrower has been discharged through the requested payment.
Bank B receives the settlement reserves and credits its customer. Its reserves rise from 100 to 160 and deposits rise from 300 to 360. Loans remain 200 and bonds remain 40. Assets therefore total 400, balanced by deposits of 360 and equity of 40. System deposits are now 300 plus 360, giving 660. System reserves are 40 plus 160, giving 200. Origination increased deposits by 60. Settlement redistributed that higher total and redistributed the unchanged reserve stock.
The central bank is a counterparty even though its full balance sheet is not displayed. It reduces reserve liabilities owed to A by 60 and increases those owed to B by 60. It need not acquire a new asset for this transfer because its total reserve liability is unchanged. The bank loan is an asset of A, not automatically an asset of the central bank. A commercial bank's decision to lend and a central bank's decision to extend credit are separate operations.
For a contrasting paper case, suppose the seller also uses A. The bank subtracts 60 from the borrower's account and adds 60 to the seller's account. A's total deposits remain 360 and reserves remain 100. The borrower's debt remains 60 in either case. The location of the recipient's account changes the originating bank's settlement need, not whether the original lending entry created a deposit. The widget uses the cross-bank case and does not expose individual customer accounts for the same-bank alternative.
Funding is how a bank obtains and maintains the financial resources supporting its assets and payments. An outgoing payment can leave A needing additional reserves even though it has a valuable loan claim. A might receive incoming payments, borrow, sell assets, or attract deposits. These options have prices and conditions. The possibility of creating its own deposit liability does not let A create a reserve asset on its own authority. It must obtain the claim issued by the central bank through an allowed transaction.
Reserve quantity and lending are consequently linked through institutions rather than a universal sequence of mechanical steps. A framework may require reserves against specified liabilities, pay interest on reserve holdings, or supply settlement credit on conditions. Central banks use different operating arrangements. A fixed reserve-ratio exercise can derive a bound under stipulated assumptions, but it cannot replace an examination of capital, funding, risk, and borrower demand. The present model performs accounting transactions. It does not calculate a lending ceiling or determine the interest rate needed to obtain funding.
Work through the accounts and assumptions
Inspect both banks' books
Currency units. Both banks remain visible. Δ means change from the opening snapshot. Choose a named experiment; changing it resets playback and all balances.
Opening balance sheets
Bank B
| Assets | Liabilities + equity | ||
|---|---|---|---|
| reserves | 100 | deposits | 300 |
| loans | 200 | borrowing | 0 |
| bonds | 40 | equity | 40 |
| Total | 340 | Total | 340 |
System deposits: 600. System reserves: 200.
Each bank has 340 assets, 300 deposit liabilities, and 40 equity. No cash or other banks are included.
Step 0 / 2
All stages and totals
| Stage | Deposits | Reserves | A equity |
|---|---|---|---|
| Opening balance sheets | 600 | 200 | 40 |
| A grants a loan of 60 | 660 | 200 | 40 |
| The borrower pays a customer of B | 660 | 200 | 40 |
Opening balance sheets. Each bank has 340 assets, 300 deposit liabilities, and 40 equity. No cash or other banks are included.
A grants a loan of 60. A adds a loan asset and deposit liability. The borrower gains a deposit and owes a loan. Reserves and bank equity do not change.
The borrower pays a customer of B. A transfers 60 reserves and removes 60 deposits. B adds 60 reserves and deposits. No further money is created by settlement.
| Books at origination | Assets | Liabilities | Equity |
|---|---|---|---|
| Bank A | Loan +60 | Deposit +60 | 0 change |
| Borrower | Deposit +60 | Loan +60 | 0 change |
Read the experiment as a sequence of snapshots
Use the Loan and payment scenario to compare three economically different states. At opening, the banks owe deposits of 600. After origination, they owe 660 while reserves remain 200. After the external payment, deposits are still 660 and reserves still 200, but their owners and bank locations have changed. The second transition cannot be described as creating another 60 of money. Doing so would count the transfer of an already created claim as a second origination.
The change labels compare each displayed category with the opening snapshot, not with the immediately preceding stage. At the final loan-and-payment state, A's deposits are back at 300 and therefore show no change from opening. That does not mean deposits never rose. A's loans remain 60 above opening and reserves remain 60 below opening. B's deposits and reserves are each 60 above opening. Reading these differences together identifies how A retained the loan asset while the associated deposit moved to B.
The displayed rows are categories, not dedicated pairs of backing assets and liabilities. Reserves appearing opposite deposits do not mean only reserves support deposits. The loan portfolio and bonds also form part of the bank's assets, while equity absorbs changes in the residual value after liabilities. The arithmetic requirement applies to total assets and total claims. It does not require the reserve row to equal deposits or the bond row to equal equity. Inferring those relationships from the table layout would invent restrictions absent from the model.
The named scenarios are separate experiments. Selecting Principal repayment does not continue the preceding loan-and-payment history. It starts again with each bank's original 200 of loans, 300 of deposits, and 100 of reserves. Its repayment of 60 leaves A with loans of 140 and deposits of 240. Adequate borrower deposits are assumed within the aggregate category. The model does not track a named borrower who first earns or transfers those funds. Reset keeps the selected scenario and returns its playback to opening.
The Loan loss scenario also begins from opening balances. Its fresh loss of 60 reduces A's loans from 200 to 140 and equity from 40 to negative 20. Deposits stay 300. This comparison isolates the difference between receiving principal and recognizing that an asset is worth less. A loss does not collect funds from the borrower or delete a seller's deposit received earlier. Negative equity is representable here, but legal resolution, prior loss allowances, and deposit insurance are not modeled outcomes.
Withdrawal pressure provides a separate liquidity contrast. After an 80 payment, A has reserves of 20. The next payment of 40 is blocked without posting entries. An assumed eligible central-bank loan of 40 then raises reserves to 60 and borrowing to 40. After payment, reserves are 20 and borrowing remains 40. Equity stays 40 throughout. The new borrowing supplies settlement capacity, not new capital. Collateral and eligibility are assumptions of that sequence, not conclusions drawn from a positive reserve balance.
Bank credit versus other lending
If a household lends an existing deposit of 60 directly to a friend, the deposit normally moves between their accounts. The lender gains a loan claim and loses a deposit; the friend gains a deposit and a debt. The combined deposit total stays the same. A commercial bank granting a new deposit-funded loan changes its own monetary liabilities, which is why the origination entries differ.
Banks can also create deposits when buying assets from nonbanks. Conversely, not every loan increases measured domestic broad money by the same amount: the recipient sector, currency, and statistical perimeter matter. Our lab includes all customer deposits of two banks and no cash. Its deposit total is an explicitly defined teaching measure, not an official M1 or M2 series.
Separate the ability to issue deposits from the decision to lend
Compare bank credit with direct lending in an additional paper case. Inez holds a deposit of 90 and lends 40 to a business whose deposit is initially 10. After transfer, Inez holds a deposit of 50 and a loan claim of 40. The business holds a deposit of 50 and owes 40. Their combined deposits remain 100. The new loan claim increases gross financial assets and liabilities outside the bank, meaning the totals before subtracting debts from claims. It has not increased the bank's total deposit liabilities.
If the bank instead grants that business a new loan of 40 while Inez makes no transfer, Inez still holds 90 and the business now holds 50. Their combined deposits become 140. The business owes the bank rather than Inez, and the bank holds the new loan asset. This contrast depends on who issues the payment claim. It does not imply that every lender called a financial institution can create bank deposits by making an entry on its own books.
A bank can also issue a deposit when buying an asset from a nonbank. In another paper example, A buys equipment valued at 18 directly from its customer and credits the customer's account by 18. A gains equipment and owes an additional deposit of 18. Equity is initially unchanged at the agreed value. The seller swaps equipment for a financial claim. Deposit creation therefore does not uniquely identify new loan principal. To diagnose a deposit increase, examine the asset or expense that accompanied the liability entry.
Why not issue unlimited deposits for loans? A bank must expect enough repayment and revenue to justify its obligations and costs. Consider a deliberately simple one-year loan of 100 with a promised final payment of 106. Assume a nine-in-ten chance of receiving 106 and a one-in-ten chance of recovering only 50. Multiply 106 by nine tenths to obtain 95.4. Multiply 50 by one tenth to obtain 5. Their sum is 100.4. Expected receipts exceed principal by only 0.4 before funding and operating costs.
If those stipulated costs are 2, expected receipts are 1.6 below principal plus costs. The headline interest amount of 6 therefore does not establish profitability. This paper calculation assumes outcomes and recoveries rather than estimating them, and it omits timing and capital costs. Its purpose is to identify the missing reasoning between an ability to post entries and a decision to accept risk. Even an expected profit would not guarantee that this particular borrower repays or that the bank has enough liquidity during withdrawals.
Capital requirements can impose another constraint because lending expands assets without automatically expanding equity. With equity fixed at 40, assets of 340 give an equity share of about 11.76%. Assets of 400 after origination give 10%. These are simple book ratios, not actual regulatory tests. They show why a balanced loan entry can reduce a capital ratio even without an immediate loss. Whether lending is allowed or attractive additionally depends on the applicable rules, other exposures, funding terms, and the borrower's proposed use of credit.
Exercises
A second loan
A bank with loans 200, reserves 100, bonds 40, deposits 300, and equity 40 grants a new loan of 25. What changes immediately, under the lab assumptions?
Hint
Do not move reserves until there is a settlement transaction.
Worked answer
| Before | After | |
|---|---|---|
| Loans | 200 | 225 |
| Deposits | 300 | 325 |
| Reserves | 100 | 100 |
| Equity | 40 | 40 |
Loans become 225 and deposits 325. Reserves stay 100, bonds stay 40, and equity stays 40. Assets and liabilities plus equity both rise to 365. This does not show that the loan met real capital or profitability tests.
A friend makes the loan
Mira lends an existing deposit of 25 to Sol, both at one bank. Compare total bank deposits with a new bank loan of 25.
Hint
Write the change in each customer account.
Worked answer
| Transaction | Mira deposit | Sol deposit | Bank total |
|---|---|---|---|
| Private loan | −25 | +25 | No change |
| New bank loan | No change | +25 | +25 |
The private loan subtracts 25 from Mira and adds 25 to Sol, leaving the bank's total deposits unchanged. A new bank loan instead adds a loan asset and deposit liability of 25. Both create borrower debt, but only the latter creates a new deposit in this comparison.
Sources and further reading
These references support the mechanisms and identify institutional context. They are optional; the explanations and worked answers above stand alone. Numerical examples are teaching cases, not live financial data or personal financial advice.
- Bank of England: Money creation in the modern economy, 2014
Bank lending, deposit creation and destruction, constraints, and asset purchases. UK institutional explanation, not a universal timetable or a current rate announcement.