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The money that banks grant as loans is not in their vaults - or only to a small extent. It is virtually created out of nothing.
Loans: Let there be money!

A loan rarely comes in cash

When a company takes out a loan of one million euros, it naturally does not receive the money in a myriad of small bills to take home. The bank credits the loan amount to the company's account. However, the bank does not own most of the money lent - neither in cash nor in an account. By lending, the bank “creates” new (book) money and thereby (temporarily) increases the amount of money in the world.

You can also create money

Turn €50 into €100
Imagine you lend a friend 50 euros. As a result, your friend has 50 euros in her hand that she didn't have before. But somehow you still have the 50 euros. You didn't give her the money as a gift, but are entitled to have your friend pay you back the 50 euros.
In economics, you would say that you have a “receivable” from your girlfriend. In the financial world, receivables are also part of the money supply. According to this logic, you now both have 50 euros - you as a receivable, your girlfriend in cash. That makes a total of 100 euros. The money supply has therefore grown by 50 euros. After your girlfriend has earned the money back with side jobs, she pays you back your 50 euros. As a result, you will only have 50 euros again, namely the one you now have in your hand.

How banks create money

The principle is very similar when banks “create money”. Unlike you, they can not only turn 50 euros into 100 euros, but even up to 5,000 euros.

1 percent security, 99 percent trust

Let's say a confectioner wants to buy a new machine and needs a loan of 5,000 euros. As security, the bank must deposit 1 percent of the loan amount (i.e. 50 euros for a loan of 5,000 euros) with the European Central Bank (ECB) as a minimum reserve. The remaining 4,950 euros are based on the bank's confidence that its customer will be able to settle the debt.

A plus on one account, a debt on the other

The bank credits the confectioner's account with 5,000 euros and at the same time has a claim for 5,000 euros on its own books. That makes a total of 10,000 euros. The confectioner buys the new machine from a factory and uses the 5,000 euros to pay for it. The factory uses the money to pay its employees and its suppliers. They in turn use the money to buy other goods. Perhaps even a cake from the confectioner.

Repayment destroys the money created

At some point, the confectioner has earned enough to repay the 5,000 euros plus interest on the loan. The outstanding receivable of 5,000 euros is canceled out by the repayment (-5,000 + 5,000 = 0).

Why loans stimulate the economy

What the bank retains as a real credit balance is the interest it has earned from the loan. But it's not just the bank that benefits: The many people who have received money from the confectioner's loan also benefit - the factory, its staff and its suppliers, in short: the economy.

Interest covers the risk

Why do you pay interest on loans?
Isn't that risky? What if the pastry chef can't pay? That can happen. And then the bank has to replace the money it has credited to the confectioner. To cover this risk, the bank charges the borrower interest.
Recommendation
Take a look at our article on the topic of money supply.
Money creation

What Dr. Dr. Money says

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