The bank's risk in money creation

Banks create money out of nothing using the money creation cycle. It may seem that the banks have nothing to lose if things don't work out and the borrowers, who's promise to repay loans underpins the value of the money that is created, default; however, this is not so.

 

When the created money in the borrower's loan account is spent, it is moved out of that loan account and into other people's accounts, even into accounts in other banks, and some of the money may be withdrawn as true cash. Once the money has left the borrower's loan account the bank has no right to retrieve it from the other people's accounts, even if the borrower defaults on their loan.

 

If the borrower defaults, and the promise to repay the loan is lost, the increase in balance in those other accounts is no longer balanced by the decrease in balance in the loan account, and there is an overall increase in the total amount of money in the bank, money that the bank must provide if the account holder wishes to withdraw or transfer it.

 

When a borrower defaults on their loan the value of that loan, which is underpinned by the borrower's promise to repay the money in the future, disappears. The bank now holds no debt in the form of a loan from which to collect the value of that money in the future.

 

When a bank lends money that it has created using the money creation cycle, it has lent not only the borrower's promise to pay the money back, but also its own risk that it may not be paid back.

 

This page is linked from:

How money is created

 

 

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