How bank loans create deposits
Bank lending creates a loan asset and a deposit liability. Payments to another bank then require settlement funds, while principal repayment reverses deposit creation.
Bank deposit creation is the expansion of a bank’s liabilities when it credits a customer account, including when it originates a loan. A customer deposit is a claim on a commercial bank; a reserve balance is a commercial bank’s claim on the central bank.
Loan origination creates two entries
Take a bank that advances a $100,000 loan by crediting the borrower’s account. The bank records a $100,000 loan asset and a $100,000 deposit liability. Its balance sheet grows by $100,000 on each side. No existing customer’s deposit has to be debited to make these entries.
The borrower receives spending power and assumes a repayment obligation. The bank acquires a repayment claim and assumes an obligation to honor the deposit. The transaction does not create $100,000 of bank equity or a corresponding increase in the borrower’s net wealth.
An outgoing payment requires settlement funds
If the borrower pays a seller at the same bank, the bank debits the borrower’s account and credits the seller’s account. Total deposits at that bank remain unchanged.
If the seller uses another bank, the originating bank must arrange interbank settlement. Where both banks settle directly in central-bank reserves, the originating bank transfers $100,000 of reserves to the receiving bank. The receiving bank credits the seller with a $100,000 deposit.
Across the two banks, the new loan and the seller’s deposit remain. The payment redistributed reserves; it did not deliver reserves to the seller or create additional reserves for the banking system.
The originating bank must obtain settlement capacity from its existing assets, incoming payments, borrowing, or another available funding arrangement. Creating its own deposit liability does not create a claim on the central bank.
Principal repayment reduces deposit money
Take a $10,000 principal repayment from an account at the lending bank. The bank reduces the customer’s deposit by $10,000 and reduces the loan asset by $10,000. Both sides of its balance sheet contract.
A repayment from another bank first brings settlement funds to the lender. Across the banking system, the payer’s deposit and the outstanding loan still decline by the principal amount.
Interest is different. An interest payment becomes bank income rather than reducing loan principal. Subsequent bank spending, including wages and supplier payments, credits recipients’ accounts.
Deposit creation has funding and risk constraints
The accounting ability to create a deposit does not establish that a loan is profitable, collectible, or permissible. Lending consumes credit-risk capacity and creates funding, capital, and operating requirements. A bank must meet outgoing payments even when the deposits created by its lending move elsewhere.
The mechanism is the same for a mortgage and a business loan credited to an account. What changes is the contract, the borrower’s repayment capacity, and the funding and risk consequences.
Questions
- Do banks lend out someone else’s deposit?
- A bank originating a loan by crediting an account creates a new deposit alongside the loan asset. It still needs funding and settlement capacity when that deposit is spent or withdrawn.
- Can banks create unlimited money?
- No. Credit losses, capital requirements, settlement needs, funding costs, and demand for viable loans constrain bank lending.
- Does repaying a loan destroy money?
- Principal repayment from bank deposits reduces outstanding loans and deposit money across the banking system. Interest payments are bank income and do not reduce the loan principal.