Part 5. How money is created
This part demonstrates the money creation process by applying the principles established so far to two example loans taken out at different banks: one, a £20,000 car loan; the other a £25,000 personal loan. We will start from scratch — that is, without any accounts — using our example banks: 1st Bank and 2nd Bank, and introduce other accounts as we need them.
Let's start with the car loan. We will need two new accounts: a loan account we will call Car Buyer's Loan Account, and a deposit account we will call Car Buyer's Deposit Account. These are both held at 1st Bank and belong to the customer buying the car. The loan is made available to the customer by a single double entry as shown in Figure 5.1.
Figure 5.1. Creation of a car loan at 1st Bank.
This single double entry can stand by itself since the accounts involved are with the same bank. We now have a balance sheet at 1st Bank as shown in Figure 5.2.
Figure 5.2. 1st Bank's balance sheet after the creation of a car loan.
The bank's equity is still zero, and the balance sheet satisfies the accounting equation. At this stage, all 1st Bank has done is made the money available to the car buyer to buy the car. The car purchase hasn't taken place yet, and the car buyer could still back out by reversing the transaction.
Let's go ahead with the car purchase. For this transaction we will need a new deposit account for the car dealer. Let's call this Car Dealer's Deposit Account and create the account at 2nd Bank. To purchase the car, the car buyer needs to transfer funds from their deposit account to the car dealer's deposit account. Let's assume that the car buyer pays £19,000 for the car after negotiating a last minute discount. This transaction is shown in Figure 5.3.
Figure 5.3. Car purchase transaction.
As this is an interbank transaction, we need to carry out a deferred settlement double entry. For this, we will need to reintroduce our 1st Bank's Loan Account at 2nd Bank and our 2nd Bank's Deposit Account at 1st Bank from before, and carry out a double entry between these accounts as shown in Figure 5.4..
Figure 5.4. Deferred settlement double entry for the car purchase transfer
The balance sheets of both banks are shown below in Figure 5.5
Figure 5.5. Balance sheets of both banks after the deferred settlement double entry.
We can see from the balance sheet that the money created from the loan persists after it is used to purchase the car. In fact it is money that is free to circulate in the economy — once it is cleared through settlement.
Now let's look at the personal loan. We will need two new accounts for the customer taking out the loan which we will call Shopper's Personal Loan Account and Shopper's Deposit Account, and these will be with 2nd Bank. The personal loan creation is shown in Figure 5.6.
Figure 5.6. Creation of the personal loan at 2nd Bank.
Again this single double entry can stand by itself since the accounts involved are with the same bank. The balance sheet for 2nd Bank is shown in Figure 5.7. (1st Bank remains unchanged.)
Figure 5.7. Balance sheet of 2nd Bank after the creation of the personal loan.
Let's now assume our customer spends £19,000 on purchases from a business we will call Alpha Stores (the amount is somewhat contrived but will be useful when we settle between banks later). We will need a new account belonging to it, which we will call Alpha Stores' Deposit Account, and open it at 1st Bank. Then we will carry out a single transaction for the purchases as shown in Figure 5.8.
Figure 5.8. Transaction for purchases made at Alpha Stores
We will also need to carry out a deferred settlement double entry, and as with the prior deferred settlement we will need to reintroduce our 2nd Bank's Loan Account at 1st Bank and our 1st Bank's Deposit Account at 2nd Bank. The double entry for the deferred settlement is shown in Figure 5.9.
Figure 5.9. Deferred settlement double entry
The balance sheets of both banks are shown below in Figure 5.10, the blue arrows showing the amounts that will need to be settled between banks.
Figure 5.10. Balance sheets of both banks after the second deferred settlement double entry.
Let's assume we have reached the end of the trading period and the banks need to settle. Let's start with 2nd Bank's accounts at 1st Bank. We can see that a transfer of £19,000 from 2nd Bank's Deposit Account to 2nd Bank's Loan Account will reduce both balances to zero. This is shown in Figure 5.11.
Figure 5.11. Double entry to reduce 2nd Bank's balance at 1st Bank.
Now let's do the same for 1st Bank's accounts at 2nd Bank. We can transfer £19,000 from 1st Bank's Deposit Account to 1st Bank's Loan Account to, again, reduce both balances to zero. This is shown in Figure 5.12.
Figure 5.12. Double entry to reduce 1st Bank's balance at 2nd Bank.
And the balance sheets after these double entries are made are shown in Figure 5.13.
Figure 5.13. Balance sheets of both banks after settling.
After settling, neither bank owes anything to the other. What we are left with are loans and deposits held by people and businesses. As far as deposit account holders are concerned, this is their money held in their accounts that they are free to spend as they wish, and as far as the loan account holders are concerned, this is the money they owe to the bank and have to pay back in the future.
This is how money is created within the banking system. No single bank itself actually creates money, but the transactions between banks results in the creation of new money.
In this particular example, the savers are the deposit holders even if the deposits are intended to be short term. As banks lend, deposits are created and hence money is created. However, money can also be destroyed, as discussed next.
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