How Banks Create Money? 

 Understanding the Magic of Credit Creation and How You can use it for Your Wealth Creation 

Ever wondered how the modern banking system never runs out of loans? 

YES! The modern banking system can multiply an initial deposit of money and create a much larger sum of loans. And it's not magic — it's the credit creation process! In this blog, I’ll explain this concept in simple terms, help you visualize how it works and how to use it wisely.

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The Starting Point: An Initial Deposit

Imagine you deposit ₹1 crore in your bank account. This money doesn’t just sit idle. Instead, the bank uses a portion of it to give loans to borrowers while keeping a part of it aside as reserves. This process forms the foundation of credit creation.

How It Works:

1. When you deposit ₹1 crore in Bank A, the bank must keep a certain percentage as reserves (called the Cash Reserve Ratio or CRR).
2. Let’s assume CRR is 10%. This means:
   • Reserves: ₹10 lakhs (10% of ₹1 crore).
   • Lending Capacity: ₹90 lakhs.
3. The bank lends ₹90 lakhs to a borrower.
4. The borrower spends the money, and it eventually gets deposited into another bank (Bank B).

Cycle Repeats:

• Bank B keeps 10% (₹9 lakhs) as reserves and lends out ₹81 lakhs.
• This process continues, with each successive bank lending 90% of the deposit it receives.

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Formula for Credit Creation

The total amount of credit created by the banking system can be calculated using the money multiplier formula:

• If the CRR is 10% (0.10), then the money multiplier is:

This means the banking system can collectively create loans worth ₹10 crores from an initial deposit of ₹1 crore.

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Graphical Demonstration of Credit Creation

Cumulative Credit Over Iterations

Below is a graphical summary of the process for initial 10 iterations:

1. Each bar represents the deposits, reserves, and loans in iterations.
2. The red line shows cumulative loans. (only in 10 steps, total credit = 6x of initial deposit) which converges toward ₹10 crores (10x the initial deposit) gradually.

The graph illustrates how the banking system builds up total credit gradually

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How you can benefit from understanding of this concept?

At the grand scale of operations, most of the times, the loan money does not exist and may not be in circulation. Only numbers are updated in the accounts of borrower and the beneficiary party (example real estate developer in case of home loan / educational institute in case of student loan). 

Understanding this concept has profound implications for both personal financial management and a broader appreciation of the economy. 

1. Recognizing the Role of Credit in Economic Growth

• Concept: Loans create money by assigning value through credit, fueling economic activity. Borrowers indirectly contribute to the overall economy by creating value to repay the loan plus interest.
• Benefit for You:
  • Understand how borrowing responsibly can contribute to economic expansion while also benefiting you as an individual.
  • See the systemic role you play in the economy, which can motivate more deliberate financial decisions.

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2. Distinguishing Between Productive and Consumptive Debt

• Concept: Loans used for productive purposes (e.g., investing in education, building a business, or purchasing assets that appreciate) create value, while consumptive loans (e.g., funding vacations or luxury purchases) add financial strain due to interest payments without long-term returns.
• Benefit for You:
• Prioritize loans for investments that yield returns—tangible (monetary) or intangible (skills, opportunities).
• Avoid falling into the debt trap by limiting borrowing for non-essential consumption.

   When considering a loan, always assess whether it will help generate enough tangible or intangible value to cover both the principal and interest.

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3. The Tangible and Intangible Nature of Value Creation

• Concept: Value from loans isn’t always directly measurable. For example:
  • A home loan provides shelter (tangible).
  • An education loan provides knowledge and career opportunities (intangible).
• Benefit for You:
  • Assess loans not just in terms of monetary ROI but also in terms of intangible benefits that improve your quality of life.
  • Align borrowing decisions with personal and professional growth objectives.

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4. Avoiding Over-consumption

• Concept: Excessive reliance on loans for consumption (e.g., gadgets, luxury items) leads to financial strain and diminished future opportunities.
• Benefit for You:
• Reinforce the habit of saving for discretionary spending rather than borrowing.
• Recognize the hidden costs of consumptive loans (interest, lost savings potential).

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5. Leveraging Loans for Intangible Value

• Concept: Some non-monetary outcomes—like peace of mind, improved health, or relationships—are worth borrowing for, provided they align with personal priorities.
• Benefit for You:
  • Balance financial metrics with personal fulfillment when evaluating the purpose of a loan.
  • Borrow judiciously for life-enriching experiences if they provide enduring satisfaction or growth.

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6. Strategic Borrowing to Accelerate Growth

• Concept: Using loans as a tool for strategic advantage (e.g., purchasing a home early to benefit from appreciation or funding a business to generate cash flow) can be transformative.
• Benefit for You:
  • Harness the power of leverage wisely to achieve milestones that would otherwise take years to attain.
  • Factor in opportunity costs when deciding whether to borrow or wait.

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By internalizing these principles, you can make smarter financial decisions, optimize the use of credit, and align your financial behavior with both personal goals and the economy's larger dynamics. 

Got questions? Drop them in the comments below!

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Prasad Yelgodkar

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Update on 15.02.2025

Present Cash Reserve Ratio is kept at 4% by RBI, so banking system can lend 96% of the total deposits. That means 96/4 = 24X lending capacity.  (Source: https://tradingeconomics.com)

Update on 24.03.2025

The following news can be interpreted as : 

More cash withdrawals cause strain for banks to maintain reserve cash as mandated by prevailing CRR. If RBI reduces CRR (say, from 4 to 3) , it will compensate for the cash withdrawn.