When a bank issues a loan to me, the money is created out of nothing on a computer. It's just a record in a database. It doesn't exist. The bank issuing the loan needs to have reserves at the central bank, but they only account for 2% of the loan amount (at least that's what's in most European countries). So basically 98 percent is created on the spot, out of nothing.

Now my question is this. Assuming there is no bank run so that everyone goes out and depletes the real money deposits the bank has, if people stop paying their loans how can the bank go bust when that money didn't exist in the first place?

If you pay back your loan plus interest, the principal disappears just like it appeared, out of nothing, and the bank keeps the interest money as its profit. So if people don't pay back their loans why can't that money just disappear and all remain fine and dandy?

closed as unclear what you're asking by Nathan L, Rupert Morrish, Dheer, JoeTaxpayer Nov 20 '18 at 11:43

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    What you are saying amounts to bank emitting the money. Only government can do that. – void_ptr Nov 19 '18 at 18:24
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    You have it backwards - when you get a loan, the money is real and it exists, full stop. You can shower yourself with the physical dollar bills if you want, there's no way you can say it's not real. It's your savings in the bank which are ephemeral - that money is being given out to other people in the form of loans. That's the money that's "just a record in the database". That money serves double duty as a real loan for someone else, and as your "unreal" savings which don't "exist" until you withdraw them. – Nuclear Wang Nov 19 '18 at 18:43
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    What do you think happens when the customer withdraws their computer record money as cash? Or pays it to an account at a different bank? – not_a_comcast_employee Nov 20 '18 at 7:11
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    And the fact that "banks create money" is all down to how we define "money". Banks (except central banks) aren't allowed to create cash. But they are allowed to create bank deposits. If you think it's weird or corrupt that banks are allowed to create money, that's really our fault as consumers for treating bank deposits as money. – not_a_comcast_employee Nov 20 '18 at 7:15
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    And by the way, I expect the reason this question is downvoted is because it shows a lack of understanding and research. Banks are not magical. – not_a_comcast_employee Nov 20 '18 at 7:18

The issue is what's a reserve. At a very basic level:

  • Jane and ten other people deposit $100 ($1,100 total deposits)

  • Joe seeks loan for $1,000

  • Bank sends Joe $1,000 (Now the bank only has $100 on reserve)

  • Joe doesn't pay :(

  • Jane and two other depositors come for their $100, but the bank doesn't have it.

That's how a bank fails. Depositors want their cash back, and the bank doesn't have it. Whether or not you would call that a run on the bank, a bank would fail if it can't meet the demands of its depositors.

The bank can't just forgive Joe and 'fabricate' a new $750 from 'thin air' because Joe did actually receive real money. So Joe owes the bank and the bank owes its depositors.

There are various regulations in place related to fractional reserves that would all be farther off topic than this question. Part of this is really about the accounting of a bank which also is way off topic. If I were you, I'd pull an annual report from a bank or two and give them a look. From the point of view of the bank, deposits are a liability, Joe's loan is an asset. The bank has a note on the balance sheet valued at $1,000 + interest. If it were to forgive Joe's debt it would ultimately mean writing down that asset, but that doesn't bring back Jane's or the other depositor's $100.

  • What about if Joe manages to pay back the $100 and only then start missing his payments. The bank will be save at this point, since it has the money if Jane wants it, right? Although the bank will incur a loss on the balance sheets for the $900 Joe owns. Is that correct? I guess my question in this case is why doesn't the bank just forget Joe if he payed back the real deposit but not the rest which was created out of thin air and instead just chooses to keep the loss? – Pete Nov 19 '18 at 19:10
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    The issue is the bank why on earth would the bank want to forget that Joe owes it $1,000? The bank handed Joe 1,000 very real dollars. I wouldn't want to forget that... (and nevermind the moral hazard that would come with zero bad loan repercussions) Separately the accounting for loans is generally based on original issue discount. OID accounting is pretty complicated and way outside the scope of this stack. But the core of this issue is Joe doesn't receive fake money, actually receives real actual money that he really actually owes the banks. – quid Nov 19 '18 at 19:53
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    and nevermind the moral hazard that would come with zero bad loan repercussions Yeah... nevermind the moral issue of the bank charging interest for money that it created out of nothing and that it didn't have in the first place (except for Jane's deposit)... But that's another thing. Thank you! – Pete Nov 19 '18 at 19:59
  • @Pete Well the other $900 came from Justin, James and Jacob, $300 each. You think they don't want their money back too? If the bank gets $100 back, it can't afford to pay Jane $100 if Jane, Justin, James and Jacob all want their money back at the same time. – not_a_comcast_employee Nov 20 '18 at 7:12
  • This answer is wrong, because the $900 isn't created from thin air. It can be thin air as long as it stays within the bank's system but as soon as the bank has to give someone the money, they have to cough up a real $1000. – not_a_comcast_employee Nov 20 '18 at 7:13

Your understanding of fractional reserve banking is incorrect. You seem to think that a fractional reserve of 10% means that if Alice deposits $10 000, the bank can immediately go and loan out $90 000. That's not how it works. Owning a bank isn't a license to print money. How it works is that the bank has to keep $1000 in reserve, and can loan out $9 000. Suppose they loan it to Bob, and Bob uses it buy a car from Charlie. What's Charlie going to do with the money? Probably put it in a bank. So now there's a bank with $9 000 in deposits, so they can go and loan out $8 100 and keep $900 in reserve. Then if that $8 100 ends up in a bank, that bank can put $810 in reserve and loan out the other $7 290. Etc. Eventually, after enough iterations, you end up with $10 000 held by banks in reserve, and $90 000 in loans. But those loans aren't "out of nowhere". Every dollar that they loaned out is backed by someone's deposit. The banks have made $90 000 in loans, but they owe $100 000 to depositors. If the people that took the loans default, the banks won't be able to pay the depositors back.

A fractional reserve requirement of 10% means 10% of the deposits must reserve. That is very different from your idea that 10% of the loans must be deposits. All of the money, not just 10%, that the bank loans out comes from deposits.

  • Thank you for this very clear and to the point explanation - I've been having a hard time grasping this concept, especially after watching some badly researched youtube videos on the subject where the makers seem to be be suffering from the same misconception.... Still dodgy as hell, especially since banks (big, respectable ones) usually own a shitload of smaller payday-loan type of companies - probably to both spread the risk and to be able to somehow increase the overall amount they can lend out. – Christoffer Bubach Dec 16 '18 at 21:42

I think you are misunderstanding the 2% reserve. It's not that they only have to have 2% of the money they loan out. It's saying they only have to keep 2% of the money that is deposited.

If I deposit 1000$, they only need to keep $20 on hand and they can loan out the other $980. The idea is that with enough accounts, nobody will ever need to withdraw more than the bank actually has on hand.

You are correct that if nobody ever wanted their money back, then not paying the loans doesn't immediately cause any problems for the bank. But you are wrong in that the money isn't created out of nothing, it's borrowed from the depositors. And if nobody payed back those loans, the bank would be losing money and eventually would either no longer be able to loan money, or they would no longer be able to allow account withdrawals (and that's when the riots begin).


The loans made by banks are funded by the deposits. If they loan all the money out, and then everybody defaults on those loans, the people who don't have loans will be unable to spend their money.

In your question you don't allow for a run, but the more losses the bank has the more likely there will be a run.

When people don't pay back the loans the bank seizes the collateral, and then tries to sell it for more than the loan balance. If they can't because housing prices are dropping, or the there is a glut of homes on the market due to the defaults, they can't make their depositors whole. Once the losses become too high the bank will struggle.

Sometimes the bank sells the mortgages to 3rd-party investors. That lowers the risk for the bank, but exposes these investors to risk. But some banks hold onto those loans and never sell them.

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    The loans made by banks are funded by the deposits. Only a part. The 2 percent. As per the "fractional reserve banking" practice. The rest of 98 percent is created out of nothing. My question is about your last sentence. Why do banks hold onto the loans since 98 percent didn't exist in the first place – Pete Nov 19 '18 at 18:40
  • I just checked the most recent annual report for my Credit Union. Loan balances make up about 90% of the value of the deposits. You propose that deposits make up 2% of the loan balances. Very different. – mhoran_psprep Nov 19 '18 at 18:46
  • The federal reserve does allow 3% reserves for balance sheets between ~16m & ~124m of deposits, but for anything larger (most banks) the reserve requirements are 10% – Nathan L Nov 19 '18 at 19:18
  • @Pete Or here's a different way you could think about it - the bank has to make loans out of deposits, but once they make a loan, if the loan stays within the bank, then it's also a deposit and (apart from the required fractional reserve) can be used to make further loans. If they give the loan in cash, it's not a deposit so it can't. – not_a_comcast_employee Nov 20 '18 at 7:17

You buy a house for $200k. You put 20% down and the bank lends you $160k "from thin air".

One small problem - the seller of the home deposits the check for $200k and upon payment, the bank now has $160k less reserves.

What's the solution? Have the bank's accountants prepare a quarterly financial statement "from thin air" ? How about a "from thin air" tax return ? Maybe even pay its employees "from thin air" ? The possibilities are endless.

  • So are you saying that once money created it's impossible to 'take it back' because it's impossible to track exactly how that money got used in the economy and what ripples it created? – Pete Nov 19 '18 at 19:28
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    The only way it gets taken back, @Pete, is when the borrower pays it back. At that point it kind of goes back where it came from - Thin air, if you will, only the bank is just going to make a new loan again now that it has reserve capacity. Except it doesn't happen $160k at a time, it happened over 15-30 years, every time the borrower sent in a payment. – Beanluc Nov 20 '18 at 0:35

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