Loans Create Deposits in Context

Introduction
Loans create deposits. Weve heard it many times now. But how well is it understood? The
phrase is typically invoked accurately, in conjunction with a rejection of the money multiplier
fable found in economic textbooks. From an operational perspective, banks do not lend
reserves to their non-bank customers. Loans create deposits is an operation in endogenous
money. And where central banks impose a level of required reserves based on deposits, the
timing of the demand for and supply of reserves in respect of such a requirement follows the
creation of the deposit it does not precede it. The money multiplier story is bunk. And loans
create deposits is correct as an observation.
Nevertheless, there is a larger context for deposits, which includes their fate after they have been
created. Deposits are used to repay loans, resulting in the death of both loan and deposit. But
there is more. As part of the birth/death analogy, there is the lifetime of loans and deposits to
consider. This sequence of birth, life, and death in total may be helpful in putting loans create
deposits into a broader context. There is potential for confusion if loans create deposits is
embraced too enthusiastically as the defining characteristic, without considering the full life
cycle of loans and deposits. Indeed, we shall see further below that deposits fund loans is as
true as loans create deposits and that there is no contradiction between these two things.
Monetary Systems
The monetary system and the financial system are constructions of double entry accounting. It
has been this way for a long time. This did not start in 1971. The fact that there was gold serving
as a fixed value backstop for certain monetary assets shouldnt obscure the fact that a monetary
system is a fiat construction at its foundation. Gold at one time was a hard constraint on the
behavior of the monetary authorities. But the authorities will inevitably create paradigms of
operational constraint and guidelines in any monetary system. These restrictions include central
bank balance sheet constraints (e.g. gold backing; Treasury overdraft constraints; supply and
pricing of bank reserves that are consistent with the monetary policy interest rate target) and
other guidelines (such as the reaction function of the policy rate to various measures of inflation,
output, or employment). The full category of potential constraints is broad and varied. But none
of this alters the fact that a monetary system is basically a bookkeeping device for the
intermediation of real economic activity. It is a construct that enables moving beyond a barter
economic system that can only be imagined as a counterfactual.
The Choice for Banking
Starting from this monetary bookkeeping foundation, a fundamental choice exists. Will the
system include a competitive banking sector? More broadly, will financial capitalism exist in
substance and form? Will there be competition? Within this landscape, will there be more than
one bank? While a banking singularity (a single, concentrated, nationalized institution) is usually
considered to be non-pragmatic, it serves as a useful theoretical reference point for understanding
how banks actually work. The competitive framework that is often taken for granted is in fact a
choice for banking system design including the presence of a reserve system that enables active
management of individual bank balance sheets.

Loans Create Deposits

When we say loans create deposits, we mean at least that the marginal impact of new lending
will be to create a new asset and a new liability for the banking system typically for the
originating lending bank at first. A bank makes a loan to a borrowing customer. That is a debit
under bank assets. Simultaneous, it credits the deposit account of the same customer. That is a
new bank liability. Both of those accounting entries represent increases in their respective
categories. This is operationally separate from any notion of reserves that may be required in
association with the creation of bank deposits.
In another version of the same lending transaction, the lending bank presents the borrower with a
cheque or bank draft. The lending bank debits the borrowers loan account and credits a payment
liability account. The banks balance sheet has grown. The borrower may then deposit that
cheque with a second bank. At that moment, the balance sheet of the second bank the deposit
issuing bank grows by the same amount, with a payment due asset and a deposit liability. This
temporary duplication of balance sheet growth across two different banks is captured within the
accounting classification of bank float. The duplication gets resolved and eliminated when the
deposit issuing bank clears the cheque back to the lending bank and receives a reserve balance
credit in exchange, at which point the lending bank sheds both reserve balances and its payment
liability. The end result is that the system balance sheet has grown by the amount of the original
loan and deposit. The loan has created the deposit, although loan and deposit are domiciled in
different banks. The system has expanded in size. The growth is now reflected in the size of the
deposit issuing banks balance sheet, with an increase in deposits and reserve balances. The
lending banks balance sheet size is unchanged from the start (at least temporarily), with loan
growth offset by a reserve balance decline.
Money Markets
In this latter example, it is possible and even likely, other things equal, that the lending bank
additionally will seek to borrow new funding from wholesale money markets and that the deposit
issuing bank will lend funds into this market. This is a natural response to the respective change
in reserve distribution that has been created momentarily for the two banks. Without further
action, the lending bank has lost reserves and the deposit bank has gained reserves. They may
both seek to normalize these respective reserve positions, other things equal. Adjusting positions
through money market operations is a basic function of commercial bank reserve management.
Thus, this example features the core role of bank reserves in clearing a payment from one bank
to another. The final resolution of positions in this case is that the balance sheets of both banks
will have expanded, indirectly connected through money market transactions that follow on from
the initial loans create deposits transaction. However, this too may be a temporary situation, as
the original transaction involving two different banks will inevitably be followed up by further
transactions that shift bank reserves between various bank counterparties and in various
directions across the system.
The Money Multiplier Fable
The money multiplier story a fable really claims that banks expand loans and deposits on the
basis of a central bank function that gradually feeds reserves to banks, allowing them to expand
their balance sheets with new loans and reservable deposits according to reserve ratios that

bind the pace of that expansion according to the reserves supplied. This is entirely wrong, of
course. In fact, bank balance sheet expansion occurs largely through the endogenous process
whereby loans create deposits. And central banks that impose reserve requirements provide the
required reserve levels as a matter of automatic operational response after the loan and deposit
expansion that generates the requirement has occurred. The multiplier fable describes a central
bank with direct exogenous control over bank expansion, based on a reserve supply function
which is a fiction. The facts of endogenous money creation have been demonstrated by empirical
studies going back decades. Moreover, the facts are obvious to anybody who has actually been
involved with or closely studied the actual reserve management operations of either a
commercial bank or a central bank. In truth, no empirical study is required the banking world
operates this way on a daily basis and it is absurd that so many economics textbooks make up
stories to the contrary. The truth of the loans creates deposits meme is pretty well understood
now at least by those who take the time to learn the facts about it.
Central Bank Reserve Injections
A central bank that imposes a reserve requirement will follow up new deposit creation with a
system reserve injection sufficient to accommodate the requirement of the individual bank that
has issued the deposit. The new requirement becomes a targeted asset for the bank. It will fund
this asset in the normal course of its asset-liability management process, just as it would any
other asset. At the margin, the bank actually has to compete for funding that will draw new
reserve balances into its position with the central bank. This action of course is commingled with
numerous other such transactions that occur in the normal course of reserve management. The
sequence includes a time lag between the creation of the deposit and the activation of the
corresponding reserve requirement against that deposit. Thus, there is a lag between two system
growth impulses loans create deposits as the endogenous feature and a subsequent central
bank reserve injection as an exogenous follow up. The required reserve injection is typically
small by comparison, according to the reserve ratio. The central bank can provide the reserves in
different ways, such as by purchasing bonds or by conducting system repurchase operations with
investment dealers. In the case of either bond purchases or system repurchase agreements,
additional system deposits might be created when the end seller (or lender) of the bonds is a nonbank. And that second order creation of deposits may be reservable as well. But what might
appear to be a potentially infinite series of reserve injections is in fact highly controlled in the
real world because the reserve ratio is relatively small. Some countries such as Canada have no
such required reserve ratio. Indeed, the case of zero required reserves nicely emphasizes the
nature of the money multiplier as an annoying analytical error and distraction from accurate
comprehension of how banks actually work. But as a separate point, central bank injections of
required reserves illustrate how not all deposits are necessarily created by commercial bank
loans. Loans create deposits is true, but not exclusive. This aspect is made clear also by the
example of central bank quantitative easing, noted further below.
The Growth Dynamic
The loans create deposits meme is best understood as a balance sheet growth dynamic, distinct
from any reserve effect that might occur as part of an associated interbank clearing transaction at
the time (e.g. the second example above) or as part of a deposit ratio requirement that might be

activated at a later date. The banking system can be visualized in continuous time, punctuated by
discrete banking transactions that are reflected as accounting entries. If one divides time into
very small time intervals, individual banking transactions can be isolated as the only transactions
that occur during a given interval of time. Thus, the growth dynamic of loans create deposits
can be conceived of as an instantaneous balance sheet expansion at the point of corresponding
accounting entries. As noted in the examples above, this expansion may then migrate across
individual banks when the lending and deposit issuing bank are different.
Deposits Fund Loans
Some interpretations of the loans create deposits meme overreach in their desired meaning. The
contention arises occasionally that loans create deposits means banks dont need deposits to
fund loans. This is entirely false. This is the point that requires emphasis in this essay.
There is no inconsistency between the idea that loans create deposits and the idea that banks
need deposits to fund loans. Bank balance sheet management must respond to both growth
dynamics and steady state conditions in the dimension of nominal balance sheet size. A bank in
theory can temporarily be at rest in terms of balance sheet growth, and still be experiencing
continuous shifting in the mix of asset and liability types including shifting of deposits. Part of
this deposit shifting is inherent in a private sector banking system that fosters competition for
deposit funding. The birth of a demand deposit in particular is separate from retaining it through
competition. Moreover, the fork in the road that was taken in order to construct a private sector
banking system implies that the central bank is not a mere slush fund that provides unlimited
funding to the banking system. In fact, active liability management is important in private sector
banking in the system we actually have. Other systems have been proposed, in which central
banks intervene in some way to adjust the landscape of competitive liability management (e.g.
the Chicago Plan; full reserves) or to subsume this competition more comprehensively (e.g. the
MMT Mosler plan). These are ideas for significant change that should not be confused with the
characteristic of competitive banking as it now exists. Some analysts tend toward language that
conflates factual and counterfactual cases in this regard. To repeat bank liability management is
very competitive in the system we have, by design. The loans create deposits meme, while true,
only touches on this competitive dynamic.
We note again that loans are not the sole source of deposit creation. A commercial banks
purchase of securities from a non-bank will typically result in new deposit creation somewhere in
the system. There are cases where deposit creation results from other liability or equity
conversion commercial bank debt redemption and stock buybacks are examples of this.
Existing fixed term deposits can convert to demand deposits and vice versa. And central bank
quantitative easing most often results in new deposit creation because the bonds that the central
bank purchases are typically sourced from non-bank portfolios, and exchanged for deposits.
Nevertheless, loans creates deposits is a reasonable reference point and standard for the process
of deposit creation.
Bank Asset-Liability Management
The loans create deposits dynamic comprises the production of much of the money that serves
as a basic source of liquidity in a monetary economy. The originating accounting entries are
simple a loan asset and a deposit liability. But this is only the start of the story. Commercial

bank asset-liability management functions oversee the comprehensive flow of funds in and out
of individual banks. They control exposure to the basic banking risks of liquidity and interest rate
sensitivity. Somewhat separately, but still connected within an overarching risk management
framework, banks manage credit risk by linking line lending functions directly to the process of
internal risk assessment and capital allocation. Banks require capital especially equity capital
to take risk and to take credit risk in particular.
Interest rate risk and interest margin management are critical aspects of bank asset-liability
management. The ALM function provides pricing guidance for deposit products and related
funding costs for lending operations. This function helps coordinate the operations of the left and
the right hand sides of the balance sheet. For example, a central bank interest rate change
becomes a cost of funds signal that transmits to commercial bank balance sheets as a marginal
pricing influence. The asset-liability management function is the commercial bank coordination
function for this transmission process, as the pricing signal ripples out to various balance sheet
categories. Loan and deposit pricing is directly affected because the cost of funds that anchors all
pricing in finance (e.g. the fed funds rate) has been changed. In other cases, a change in the term
structure of market interest rates requires similar coordination of commercial bank pricing
implications. And this reset in pricing has implications for commercial bank approaches to
strategies and targets for the compositional mix of assets and liabilities.
The life of deposits is more dynamic than their birth or death. Deposits move around the banking
system as banks compete to retain or attract them. Deposits also change form. Demand deposits
can convert to term deposits, as banks seek a supply of longer duration funding for asset-liability
matching purposes. And they can convert to new debt or equity securities issued by a particular
bank, as buyers of these instruments draw down their deposits to pay for them. All of these
changes happen across different banks, which can lead to temporary imbalances in the nominal
matching of assets and liabilities, which in turn requires active management of the reserve
account level, with appropriate liquidity management responses through money market
operations in the short term, or longer term strategic adjustment in approaches to loan and
deposit market share. The key idea here is that banks compete for deposits that currently exist in
the system, including deposits that can be withdrawn on demand, or at maturity in the case of
term deposits. And this competition extends more comprehensively to other liability forms such
as debt, as well as to the asset side of the balance sheet through market share strategies for
various lending categories. All of this balance sheet flux occurs across different banks, and
requires that individual banks actively manage their balance sheets to ensure that assets are
appropriately and efficiently funded with liabilities and equity.
In examining all of these effects, it is helpful to consider the position of the banking system in its
totality, in conjunction with the position of individual banks that constitute the whole. For
example, the US commercial banking system is composed of thousands of individual banks.
Between discrete loans create deposits events, the banking system is in continuous balance
sheet churn. Specifically, deposits are moving back and forth between individual banks, as a
matter of normal payment system operations. They are also moving and inter-converting in the
form of term deposits at both the retail and wholesale level. This overall liquidity churn feeds
economic activity of all sorts, where households, businesses, and governments are making

payments to each other for various goods and services and other types of transactions, and are
making choices about the portfolio structure of their liquid assets. This is the core liquidity
provided by the banks to their customers. And this is the stuff that involves a good deal of
transferring of reserves back and forth between banks, in order to affect accounting completion
of balance sheets that are in continuous flux in size and composition.
Bank Reserve Management
The ultimate purpose of reserve management is not reserve positioning per se. The end goal is
balance sheets that are in balance, institution by institution and where deposits fund loans,
alongside various other asset-liability matching configurations. The reserve system records the
effect of this balance sheet activity. The reserve account is the inverse exogenous money image
of the nominal configuration of the rest of the balance sheet. The balance sheet requires asset
liability management coordination in order to match up assets and liabilities both in nominal
terms and in a way that is financially effective. And even if loan books remain temporarily
unchanged, all manner of other banking system assets and liabilities may be in motion. This
includes securities portfolios, deposits, debt liabilities, and the status of the common equity and
retained earnings account. And of course, loan books dont remain unchanged for very long, in
which case the loan/deposit growth dynamic comes directly into play on a recurring basis.
Conclusion
In summary, the original connection by which deposits are created by loans typically disappears
at some point following deposit creation at the micro bank level and/or the macro system level.
The original demand deposits associated with specific loan creation become commingled as they
move back and forth between different banks. And they not only move between banks, but they
can change in form within any bank. They can be converted into term deposits or other funding
forms such as bank debt or common and preferred stock. The task of dealing with this
compositional flux falls under the joint coordination of bank asset-liability management and
reserve management. The overarching point of observation is that both system growth and
system competition for existing balance sheet composition are in constant operation. Loans
create deposits only describes the marginal growth dynamic at the inception of deposit creation.
Deposits fund loans is the more apt description that applies to a good portion of what
constitutes ongoing balance sheet management in competitive banking.