How banks create money out of thin air?

A majority of the people are of the opinion that banks simply act as intermediates and lend out deposits that savers place with them. This is simply not true. Banks are the creators of money and not the intermediates. When someone takes a loan, the bank does not typically do so by giving them banknotes guaranteed by the nation's central bank. Instead, it credits their bank account with a bank deposit of the size of the loan. At this moment, the new money is created.

This new money is generally accepted as if they were banknotes guaranteed by the central bank. About 95-97% of the money that we use in our everyday lives are actually bank deposits that are guaranteed by commercial banks. For example, if you go to a coffee shop and pay with a JP Morgan credit card, you are paying the coffee shop in JP Morgan IOUs. IOUs are basically documents acknowledging debt. These IOUs are treated as banknotes guaranteed by the central bank because everyone trusts the commercial bank.

So, in essence, banks do not need you to deposit your money in order for them to give a loan to someone. They simply create electronic money on the spot and lend it. However, they ask you to deposit your money in the bank as it is the cheapest option for them to balance their assets and liabilities. One must also note that although banks can create electronic money independently, they must do so by following the rules set by the central bank. In normal times, this regulation is carried out by setting interest rates. The central bank can also affect the amount of money directly through purchasing assets or ‘quantitative easing’.

References:

1) Money creation in the modern economy by Michael McLeay, Amar Radia and Ryland Thomas of the Bank’s Monetary Analysis Directorate

2) Banks do not create money out of thin air by Pontus Rendahl, Lukas B. Freund

3) Why Do Banks Want Our Deposits? Hint: It’s Not to Make Loans by Ellen Brown