Banking and money supply is not what many people think. They look at banks as intermediaries that take deposits and lend money, but this view doesn’t accurately reflect what’s happening. In reality, banks are creators of the money supply.

The term “deposit” can be misleading. Legally speaking, when you deposit money in a bank, you are not placing it in custody; rather, you are effectively making a loan to the bank.

The concept of a deposit as a traditional bailment or custodial arrangement is not supported by law. Courts have clarified that when you deposit money, it becomes a loan to the bank rather than a physical holding of funds.

So, banks do borrow money from the public in the form of deposits. However, when it comes to lending, the situation is different from what most people assume.

Legally, banks are not in the business of lending money per se. Instead, they are involved in purchasing securities.

Here’s how it works in practice:

When you apply for a loan, you sign a promissory note, which legally constitutes a security. The bank then purchases this promissory note.

What seems like a straightforward loan from the bank’s perspective is actually a purchase of this note.

In reality, the bank’s process differs from its public portrayal. When you’re given a loan, the funds are not transferred from anywhere within or outside the bank.

Instead, what happens is that the bank records its debt to you in its accounting system. This record, often referred to as a deposit, is simply an entry in the bank’s books indicating how much it owes you.

There’s no physical transfer of money.

Banks create the money supply through this accounting practice.

Approximately 97% of the money supply consists of bank deposits, which are essentially created out of nothing when banks issue loans. They record what is essentially an accounts payable from the loan contract as a customer deposit. This practice involves restating liabilities as deposits, with no actual deposit of money taking place.

Banking and Money Supply Process

Based on double-entry accounting principles, here’s a simplified breakdown:

Deposits

When customers deposit money, they’re actually lending it to the bank. The bank records this as a liability on its balance sheet and creates an account showing how much it owes the customer. This account is often referred to as a deposit, but it’s essentially an accounts payable.

Loans

When a customer applies for a loan, they are creating a promissory note.

The bank buys this note and records it as an asset.

On the liabilities side of the balance sheet, the bank creates an account payable that the customer can access. This is not a transfer of funds but rather a bookkeeping entry of banking and money supply.

In essence, banks are not transferring money but creating ledger entries to represent debts and loans.

The real money creation happens when customers sign promissory notes, which banks then record as new money in their accounts.

This understanding challenges traditional views of banking and money creation, highlighting the complex interplay between accounting practices and financial operations.