How Banks Create Money Through Lending, A Clear Guide to Credit Creation and Modern Financial Intermediation
A clear explanation of how banks create money through credit issuance. The article shows why loans generate deposits, how central banks guide the process, and why trust and regulation shape the stability of modern money.
By Dr Ohio O. Ojeagbase FICA, SFIDR
Abstract
Traditional treatments of financial intermediation often describe banks as passive channels that transfer pre‑existing savings from surplus units to deficit units, a view that obscures how modern banking systems actually work. More recent theoretical and empirical research demonstrates that commercial banks create new money endogenously through the act of extending credit, with deposits appearing on the liability side of their balance sheets at the moment loans are booked, rather than simply reallocating a fixed pool of savings. This article analyzes the contemporary credit creation process in detail, highlighting how balance sheet mechanics, capital regulation, and risk management practices jointly determine the volume and composition of bank‑generated money in the real economy.
The discussion then examines the regulatory, legal, and institutional infrastructures that discipline and constrain this money creation capacity, including capital adequacy frameworks, liquidity requirements, resolution regimes, and supervisory oversight developed in the post‑crisis Basel architecture and related national implementations. Particular attention is given to how these regimes interact with macroprudential objectives, procyclical risk weights, and the political economy of financial stability, offering advanced students a structured lens through which to understand why constraints on bank credit creation differ across jurisdictions and over time. Beyond formal rules, the article evaluates the psychological, behavioral, and contractual foundations that sustain trust in financial claims, exploring how expectations about enforcement, reputational capital, and narrative framing shape both creditors’ willingness to extend funds and borrowers’ incentives to honor obligations.
By integrating insights from heterodox monetary theory, modern banking literature, and empirical studies of financial crises, the article aims to readers a rigorous but accessible framework for analyzing financial intermediation as an active, money‑creating function embedded within complex regulatory and social structures.
Credit Creation and the Architecture of Modern Money
For decades, introductory theories of financial intermediation suggested that banks primarily function by channeling deposits from surplus agents to deficit agents. Although pedagogically convenient, this perspective misrepresents the true nature of modern banking. Empirical and institutional analyses across advanced economies demonstrate that banks create money endogenously through credit extension rather than passively reallocating pre-existing deposits (Bank of England, 2014; Werner, 2014).
Modern Money as Digital Credit
The first conceptual step is recognizing that modern money is largely digital. Physical currency forms only a small share of the broader money supply. Most money exists as electronic entries on bank balance sheets. When a bank extends a loan, it generates a new deposit by crediting the borrower’s account with funds that did not previously exist in the economy (McLeay et al., 2014).
This dual-entry expansion increases both assets (the loan) and liabilities (the deposit). The borrower now possesses purchasing power newly created through the banking system. In this sense, money emerges not from prior savings but from the banking sector’s willingness to create credit. Here hoping that the borrowers would have enough sense to operate by integrity in business mindset to ensure that what is on the loan contract is followed to the later without excuses.
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Loans Create Deposits, Not the Reverse
The empirical evidence contradicts the textbook claim that deposits create the basis for lending. Instead, the act of lending itself expands deposits. When a bank approves a ₦5,000,000 loan, it does not move funds from another customer’s account. It simply records a new deposit for the borrower (Jakab & Kumhof, 2015).
This process aligns with post-Keynesian and endogenous money theories, which argue that the supply of credit is primarily determined by banks’ assessments of creditworthiness, regulatory limits, and macroeconomic expectations, not the supply of deposits (Lavoie, 2014).
Thus, every loan creates new money; every repayment extinguishes it.
Fractional Reserves and Liquidity Backstops
The fractional reserve system deepens the misconception that deposits “fund” loans. While reserve requirements historically constrained lending, many advanced economies today have no statutory reserve requirement (Borio & Disyatat, 2011). Instead, liquidity creation is constrained by:
- Capital adequacy rules
These regulatory tools ensure that banks maintain enough liquid assets to meet short-term obligations and withstand systemic shocks. Lending capacity therefore depends not on deposits but on capital strength, liquidity buffers, and risk management frameworks.
The Central Bank as Enabler and Governor
Central banks shape the environment within which commercial banks create money. Although they do not directly provide deposits for every loan made, they regulate the boundaries of credit expansion through:
- Policy interest rates
- Standing lending facilities
- Open market operations
- Prudential regulations
- Interbank settlement systems
Through these mechanisms, the central bank effectively governs the pace and scale of credit creation, influencing monetary aggregates and macroeconomic conditions (Borio, 2012).
- ForDeposit Money Banks (Commercial Banks), the CRR is 45.00%.
- For Merchant Banks, the CRR is 16.00%.
- A special CRR of 75.00% is applied to non-TSA public sector deposits. These rates were last adjusted in September 2025 and retained at the most recent Monetary Policy Committee (MPC) meeting held in November 2025. The CBN uses the CRR as a key tool to manage liquidity and control inflation within the Nigerian economy.
Trust as the True Constraint
Despite technical regulations, the most important constraint in money creation is trust. The banking system’s stability depends on:
- The credibility of borrowers
- The enforceability of contracts
- The value of collateral
- Confidence in institutional processes
Historical crises from the Great Depression to 2008 show that when trust erodes, lending contracts, liquidity dries up, and economic activity slows (Minsky, 1986). Money creation is therefore not merely a mechanical process; it is a social contract grounded in institutional reliability.
When contract enforcement weakens, defaults normalize, and the moral gravity underpinning credit dissolves. Without credibility, banks restrict lending, which reduces money creation and slows economic growth.
Deposits Follow Loans
Once loans are disbursed, borrowers spend the funds, and those expenditures ultimately settle as deposits across the banking system. Thus, deposits gravitate from the lending process rather than precede it (Bank of England, 2014).
This feedback loop ensures that the banking system maintains liquidity even as individual banks compete for deposits generated through credit expansion.
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Conclusion
Contemporary monetary systems are built on the principle of endogenous money creation. Banks do not merely redistribute existing money; they create new money through lending. Deposits do not fund loans; loans generate deposits. Central banks steer the process through regulatory and monetary frameworks, whilst trust expressed through contract enforcement and financial discipline anchors the entire system.
For doctoral scholars, this framework challenges traditional assumptions about financial intermediation and invites deeper examination of the psychological, institutional, and regulatory dynamics that sustain economic life. Modern money is ultimately a product of credit, confidence, and credible institutions, not merely printed currency or accumulated savings that we had in the last administration in Nigeria engaged in the printing of currency.
References (APA 7th Edition)
- Bank of England. (2014). Money creation in the modern economy. Quarterly Bulletin, 54(1), 14–27. provided a detailed explanation of how money is created in the contemporary economy, challenging several popular misconceptions
- Borio, C. (2012). The financial cycle and macroeconomics: What have we learnt? Bank for International Settlements Working Paper No. 395.
- Borio, C., & Disyatat, P. (2011). Global imbalances and the financial crisis: Reassessing the role of international finance. Asian Economic Policy Review, 6(2), 198–216.
- Jakab, Z., & Kumhof, M. (2015). Banks are not intermediaries of loanable funds – and why this matters. Bank of England Working Paper No. 529.
- Lavoie, M. (2014). Post-Keynesian economics: New foundations. Edward Elgar.
- McLeay, M., Radia, A., & Thomas, R. (2014). Money creation in the modern economy. Bank of England Quarterly Bulletin, 54(1), 14–27.
- Minsky, H. P. (1986). Stabilizing an unstable economy. Yale University Press.
- Werner, R. A. (2014). Can banks individually create money out of nothing? — The theories and the empirical evidence. International Review of Financial Analysis, 36, 1–19.
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