Where does the money come from that we borrow from a bank?

It is remarkable that, despite our advanced financial systems, we still do not have a clear answer to this fundamental question: where does the money we borrow from a bank actually come from? In the early development of banking systems, banks could only lend out what they actually had on deposit. Today, however, the situation has changed dramatically, and the modern banking system allows banks to create digital money, thereby expanding the total money supply in the economy.

I have personally spent a great deal of time trying to understand this, as it initially appears deceptive that banks should be able to create money out of nothing. When I began studying the subject more closely, I encountered a theory known as fractional reserve banking. This theory has long dominated the description of how banks operate.

Fractional Reserve Banking: A misleading picture?
The theory of fractional reserve banking states that banks must hold a certain proportion of their deposits as reserves, and that they can only lend out a portion of those deposits. Through this system, money can be “multiplied” in the economy through loans and deposits, but fundamentally every loan is based on an existing deposit. This process therefore allows for a certain increase in the money supply, but in theory there would not be more money in circulation than what existed to begin with, since each bank can only lend out part of what it has, while the rest remains locked in an account.

What is interesting is that even though this theory implies an increase in the money supply through lending, the amount of money actually available for circulation is limited. It may appear as though the bank is creating new money, but in reality all money is still tied to the original deposits.

Credit Creation Theory: Money out of thin air?
But fractional reserve banking is not the only theory. Critics have long highlighted another theory, known as credit creation theory, which argues something more radical: that banks actually create money entirely without any form of backing. Many also refer to this theory as fractional reserve banking, which is misleading. When a bank grants a loan, it creates new money “out of thin air” by crediting the borrowed amount to the borrower’s account, without any corresponding deposit being made by someone else. Here too, there is a reserve requirement, which in this case means that the bank must have backing for a portion of the newly created amount.

This means that the bank does not merely lend out part of its reserves, but instead creates the entire loan amount directly. Money is injected into the system as new digital deposits, meaning that each loan increases the total amount of money in the circulating economy. This has far-reaching implications for our understanding of money and how the banking system operates.

Two theories, the same terms — different outcomes
What puzzled me most during my research was that both of these theories use similar terminology but lead to completely different practical outcomes. According to fractional reserve theory, the bank only lends out a portion of the money that already exists within its system, whereas under credit creation theory, new money is created with every loan. This, of course, makes an enormous difference when it comes to the origin of money and how the money supply grows in the economy.

After examining this more closely, I have come to the conclusion that fractional reserve banking theory largely functions as a smokescreen. For a long time, it has presented an image of banks merely managing and safeguarding deposits, when in reality—according to credit creation theory—they actually create money out of nothing. The concepts have therefore been deliberately conflated to make it possible to confuse and discredit those who point out the truth—that money is created out of thin air.

What are the consequences?
The question of which theory is correct has far-reaching consequences for both research and policy. If it is indeed the case that banks create money out of thin air, then this is no longer merely a question of how money is managed, but of how the entire economic system functions. And this is where the real controversy lies—different central banks, and sometimes even the same central bank, have at times expressed support for different theories simultaneously.

It is time we gain clarity on this. Banks do not appear to be merely financial intermediaries. They create the money we use, and this happens more or less without any real connection to actual deposits or reserves. The question we should all be asking ourselves is: What does this mean for society and for economic justice?

In the study “Can banks individually create money out of nothing? — The theories and the empirical evidence,” Richard A. Werner demonstrates that banks can, in fact, create money out of nothing. His books, Princes of the Yen and Lords of Finance (Mammons Furstar), inspired me to dig deeper into this subject. To me, this is one of the most important questions concerning how the world is governed—and how corruption is sustained. Endless money means endless bribery.

Watch Richard explain how it works in this video:

Mikael Cromsjö, Where does the money come from that we borrow from a bank?