Not investment advice. Educational reading. See Disclaimer.
L.11 · BEGINNER · 2 MIN
How Banks Create Money (and Why Reserves No Longer Bind)
The old textbook chapter on banking starts with 'banks accept deposits and lend them out,' followed by an arithmetic multiplier showing how $100 of new reserves becomes $1,000 of new deposits. The chain of logic was elegant and is now wrong. Understanding what actually limits bank lending today is essential for reading bank earnings, the credit cycle, and Fed balance-sheet policy.
Banks do not lend out existing deposits — they create new deposits when they extend a loan. A bank that approves a $300,000 mortgage credits the borrower's checking account with $300,000 of new deposit money. That deposit did not come from another customer's savings; it was created on the bank's balance sheet by the act of lending.
§ 02
Era
What constrained lending
Why it changed
Pre-2008 (scarce reserves)
Required reserves, money multiplier
Reserves were genuinely scarce; Fed controlled by adjusting quantity
2008-2020 (ample reserves)
Capital ratios primarily; reserves abundant
QE flooded system with reserves; Fed switched to administered rates
Post-2020 (zero reserve requirement)
Capital ratios exclusively
Fed dropped required reserves to zero; capital is the only binding floor
§ 03
Capital is the new constraint. Each loan a bank books consumes equity capital under Basel III risk-weights: a residential mortgage uses less capital than a commercial real estate loan, which uses less than an unsecured corporate loan. A bank running low on CET1 capital must either issue stock or stop booking new loans — capital scarcity, not deposit scarcity, is what slows lending in modern downturns.
§ 04
The money supply (M2) grows when banks make loans. The Fed influences the PRICE of money (rates) but does not directly control the QUANTITY of bank-created money — that is a function of bank willingness to lend AND household / corporate willingness to borrow. This is why aggressive QE alone does not always produce strong credit growth: if banks are capital-constrained or borrowers are not demanding loans, reserves accumulate and inflation does not follow.
§ 05
In the Markets view, look at the latest M2 money supply growth rate (typically reported as a year-over-year percentage change). Compare M2 growth to nominal GDP growth — when M2 grows much faster than GDP, inflation pressure builds. When M2 contracts (rare), credit is breaking down somewhere.
§ 06
A big regional bank reports earnings and management says, 'We are slowing loan growth to manage our CET1 capital ratio above the regulatory minimum.' What does this tell you about their environment?
Five questions · AI feedback
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Sit with the ideas.
A textbook says banks 'lend out deposits' and a $100 deposit creates $900 of new money through a 10x money multiplier. The reality after 2020 is different: required reserves were dropped to zero, banks routinely hold trillions in EXCESS reserves, and lending growth has slowed even as reserves ballooned. What actually binds bank lending today?
