This is how money is created and what it means for your savings.
Every commercial bank can create money through loans but risks bankruptcy in the event of a bank run. Could cryptocurrencies like Bitcoin and Ethereum, with their decentralized nature, offer a secure alternative to traditional banking systems?
Most of us carry only a small amount of cash. The majority of our money is kept in the bank. We trust that it is safe there and that we can withdraw it at any time. We also assume that our savings will retain their value over the long term and that we will be able to buy as much with it in 10 or 20 years as we can today. This trust in the traditional banking system and the stability of the currency is based on years of experience and the assumption that central banks and governments manage monetary policy responsibly.
We desire security and stability for our money, but these are not guaranteed in our monetary system. Inflation alone continually devalues our money. Inflation can result from increased demand, supply fluctuations, or the unlimited expansion of the money supply. Central banks, such as the European Central Bank (ECB) or the Federal Reserve, contribute to this by creating cash and electronic money. They do this by issuing loans to banks and purchasing government bonds. , you can read more about inflation.
What many of us don’t know: not only does the central bank engage in
, but so do commercial banks themselves. This is known as "internal" money creation or credit money creation. Let’s take a closer look at today’s banking system: perhaps you’ve wondered where banks get all the money they lend as personal or business loans. Many people believe that these loans come from the deposits we have in our bank accounts. That’s not the case. Banks grant loans largely independent of deposits. They essentially create this money out of thin air. This phenomenon of credit money creation, regulated by central banks such as the European Central Bank (ECB), the Swiss National Bank (SNB), or the Federal Reserve, is a crucial aspect of the modern financial system.Let’s explain this with a concrete example:
Carla Credito needs €20,000 for her hairdressing business. Her bank grants her this loan, but the amount doesn’t come from another customer’s bank account. Instead, the bank "creates" the €20,000 "out of thin air" and credits it as a balance on Carla Credito’s account. In its bookkeeping, the bank records the €20,000 on the liabilities side of the balance sheet as a liability (the deposit) to Carla Credito. Since banks use double-entry bookkeeping, the same amount is also recorded on the assets side as a claim (loan receivable) against Carla Credito. This is because Carla Credito is obligated to repay the €20,000. In this way, the bank has created new money—€20,000 that didn’t exist before. However, this additional money is destroyed once Carla Credito repays the loan.
This is referred to as "book money." The amount is recorded but can be used just like cash. Carla Credito uses it for her hairdressing business. As a result, the money circulates in the economy and can be deposited back into bank accounts. Through this process of lending, spending, and depositing, the money within the banking system multiplies. This is known as money creation through credit money.
Limited money creation
When creating money, banks are partially bound by regulations, such as liquidity requirements. This refers to the amount of cash they must always keep on hand to allow customers to withdraw cash.
Additionally, they are required to hold a certain percentage of their loan amounts as a monetary reserve, called the "minimum reserve," in their central bank account. In the Eurozone, the minimum reserve ratio is currently set at 1%. This means that if a bank wants to issue a loan of €10,000, it must deposit €100 as a minimum reserve.
The central bank has the ability to adjust the minimum reserve ratio within certain limits. The minimum reserve acts as a liquidity buffer for commercial banks to ensure customer withdrawals. This tool is used by the central bank to limit money creation in the private banking sector. By doing so, it can influence the amount of money available to banks for lending, which in turn affects interest rates and the stability of the currency's value. The minimum reserve system is legally regulated, in the EU through the ECB statute and the EC Council regulation.
The money creation model of banks carries various risks and is closely tied to the concept of credit money creation. Banks issue loans that are partially not covered by deposits but instead created "out of thin air." This phenomenon, known as the credit multiplier, relies on the principle of minimum reserves that banks must hold at central banks. However, there is a risk of a bank run, where a large number of customers simultaneously try to withdraw their deposits, leading to liquidity problems. As a result, the bank may become insolvent, potentially causing customers to lose their deposits.
A recent example of a bank run occurred in March 2023 in the United States, affecting the Silicon Valley Bank and Silvergate Bank. This echoed past events, such as the financial crisis after 2007, which led to runs on banks like the UK's Northern Rock Bank and Switzerland's UBS. A historical example is the wave of bank failures following the 1929 New York stock market crash, during which about 40% of American banks became insolvent.
The practice of bank money creation is a topic of intense discussion today. Critics argue that banks predominantly create money during economic booms but fail to do so during crises, resulting in a money shortage. This behavior exacerbates bubbles, financial crises, and inflation.
Unsurprisingly, there is a growing call for tighter control over money supply growth. Some even advocate for alternative financial systems that offer greater security and stability for deposits. To address these challenges sustainably, various alternative financial models are being explored, emphasizing fair, democratic, and decentralized principles—such as cryptocurrencies like Bitcoin, Ethereum, or Solana. Unlike traditional currencies, cryptocurrencies cannot be devalued by central banks or governments. Furthermore, crypto assets cannot simply vanish in the event of a crisis. As a result, it is no surprise that more people see cryptocurrencies as a potential solution for a stable and independent monetary system.
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