How do Banks Make Money?

You might think that the role of commercial banks is to accept deposits from the public and channel them into projects, where the bank can lend the money out at higher rates of return. You would be wrong.

When you hear the world deposit, you might think that the bank is storing the money for you, therefore acting as a custodian. It isn’t. When you deposit your money in the bank, in a legal sense, you are lending your money to the bank.

Money Creation

Banks, currently, are the effective creators of the money supply. They produce money. They do this by selling promissory notes, such as mortgages, car loans or business loans. Deposits are more like a by-product of the money creation process.

This is brilliantly explained by Professor Richard Werner (who happens to also be the guy who came up with the terms Quantitative Easing), in the following video:

Richard Werner: Essentially, if we want to produce something we need funding. So there is a role for banking in almost everything that happening in the economy. But what exactly is that role? Banks are being thought of as intermediaries. This is not really what is happening. They are creators of the money supply. 

Interviewer: So, you are firmly of the view that banks create money out of thin air?

Richard Werner: I produced the first empirical study to prove that, in the 5,000-year history of banking. Banks are thought of as deposit-taking institutions that lend money. The legal reality is that banks don’t take deposits and banks do not lend money. So, what is a deposit? A deposit is not actually a deposit. It’s not a bailment. It’s not held in custody. 

At law, the word deposit is meaningless. The law courts in various judgements have made it very clear. If you give your money to the bank, even if it is called a deposit, this money is simply a loan to the bank. So, there is no such thing as a deposit. 

Banks borrow from the public. That much we have established. What about lending? Are they lending money? No, they don’t. Banks don’t lend money. At law, it’s very clear. They are in the business of purchasing securities. That’s it. 

So you say: “Ok. don’t confuse me with all that legalese. I want a loan.” Fine, here is the loan contract. Here is the offer letter. And you sign. At law, it’s very clear. You have issued a security, namely a promissory note. And the bank is going to purchase that. That is what is happening. 

Interviewer: Put it in laymen terms.   

Richard Werner: It means that what the bank is doing is very different from what it presents to the public that it is doing. How does this fit together? You say “fine, the bank purchases my promissory note. But how do I get my money?” 

The bank will say, “you will find it in your account with us.” That will be technically correct. If they say, “we will transfer it to your account,” that’s wrong. Because no money is transferred at all. From anywhere inside the bank or outside of it. Why? Because what we call a deposit is simply the bank’s record of its debt to the public. Now, it also owes you money and its record of the money it owes you is what you think you are getting as money. And that is all it is. 

And that is how the banks create the money supply. The money supply consists of 97% of bank deposits. And these are created out of nothing by banks when they lend. Because they invent fictitious customer deposits. Why? They simply restate, slightly incorrectly in accounting terms, what is an account payable liability arising from the loan contract, having purchased your promissory note, as a customer deposit. 

But nobody has deposited any money.