Debit, credit, banco! By Rudo de Ruijter

Dandelion Salad

By Rudo de Ruijter

In “Secrets of money, interest and inflation” [1] I have exposed many things about banks. There were many readers who still had questions about the way banks make money. That is not so surprising, for it is really something that is astonishing. Some people cannot believe it. That cannot be, can it?

In this article we will explain this money creation in detail. To avoid misunderstandings: banks make money, but they don’t make bank notes. Only the central bank is allowed to print banknotes. Ordinary banks do it simpler. They make money by inscribing numbers on their balance sheet and lend that out. And on the lent out money they collect interest. That is how the bank grows rich.

So, banking is a nice game. But, as with all games, there are rules. These are imposed by the central bank. That does not mean that everything always goes perfectly then. Things can become a mess, like we know from today’s credit crisis. We come back to that later.

Let us see how banking works. Banking is mainly a question of bookkeeping. I find bookkeeping boring, so I will only show the interesting parts. Here you can first have a look at the bookkeeping of a bank, to be more precise, of its balance sheet. To keep it simple, I didn’t put everything on it. On the left hand side, the debit or assets side, you find what the bank has. It is also called the Activa. On the right hand side, the credit or liabilities side, you find what the bank owes to others, like the Current accounts, also called Transaction deposits. They are often called passiva. On this side you also find what the bank owes to its owners, the capital. When you substract all the passiva from the total of the activa, you find the capital.

(At a bank the numbers are that high, that on the balance sheet the last three figures are generally omitted. Then you have to multiply all amounts by 1000.)

Now let’s set the banker to work and see how he does things. It is not necessary to see the complete balance all the time. At each stage we will have a look at the part that changes. To keep it simple we’ll work with small amounts. In reality they are much bigger. We will also mention the principal rules. We start easily.

Bank takes notes in deposit

John has 1000 euros in banknotes and brings them to the bank. The banker says “thank you” and inscribes the 1000 euros on the balance sheet as an asset of the bank. “Banknotes in cash: + 1000 euros. But the bank will also have to give the 1000 euros back to John one day. So the bank has also a debt to John. The banker writes at the liabilities side: Checking account John: +1000 euros.

This way many customers bring their money at the bank. By experience the banker knows that a lot of customers will leave most of their money for a long time. Daily some money goes, but other money comes. So the bank has more bank notes than for its daily needs.

Now the bank is going to lend out the bank notes that it does not need for its daily use. On that money it can collect interest. And the more the bank lends out, the more interest it can collect. But it has to take care, that it keeps suffisciently in cash, in case John comes in to collect money. And if John doesn’t come, other customers will surely come. How much money the bank should keep in its pay-desk? Well, in most countries the central bank dictates the rule. We will take the US as example [2]: “For all the money in transaction deposits the bank has to keep at least 10% cash reserves.” So, of the 100 euros of John, the bank may lend out 900 euros. (In Europe the liquidity varies per country from 2% to 25%. [3] )

Bank lends out banknotes

Peter wants to buy a laptop and asks for a loan of 850 euros. The bank lends him 850 euros in banknotes. Customers who owe money to the bank are inscribed under Debtors (they owe to the bank = the bank has a claim on them.)

Hey, how is that possible? At first there were only 1000 euros and now John has 1000 euros and Peter has 850 euros! Yes, we have been fooled. The banker simply juggles the 850 euros from his hat. John still has 1000 euros in his account and Peter now has 850 euros for which he has to pay interest. Debit, credit, banco!

So that is the secret of the banker. You lend out the money and pretend you still have it!

Now, don’t be angry with your banker. This way of banking has grown historically. In fact is comes from the time of the goldsmith. There weren’t any banknotes at that time yet, but receipts for coins of gold that the goldsmith kept in his vault. The goldsmith lent out money in the form of such receipts. The secret of the goldsmith was, that he lent out more receipts than he had gold.

The goldsmith

In the days that people were still paying with golden coins, many gave them in deposit at the goldsmith’ and paid him a small compensation for it. At that time he was the only one with a safe vault. The customers got a receipt, with which they could collect their coins later. But the customers started to use these receipts to pay for their purchases. This way they did not have to go on the street with their gold. And whoever received the note could go and collect the gold at the goldsmith, if he wished. By storing other people’s gold, the goldmith got rich while sleeping.

More and more often there were also people who wanted to borrow money from him. But in stead of taking gold coins home, they rather left the borrowed coins in the vault and asked for a receipt. On the loans the goldsmith collected interest. At the beginning he only lent out his own gold. (That is to say, he lent out notes with his own gold as collateral.) But when more and more people wanted to borrow money, he started to cheat. He started to lend out notes that were backed by the gold of his depositors. And those customers already had received a note for the same gold! This way the goldsmith lent out more and more notes and collected more and more interest. And as long as not too many people came in at the same time to exchange their notes for gold, nobody would find out.

Empty vault

This is still the way it goes today. Everyone has amounts in his checking accounts and as long as not too many claim their money at the same time, nobody notices, that the vault is nearly empty. Nearly all money is lent out. Many people still think, that the bank is rich and lends out its own money. Not so. The bank itself has no money for that. The bank always lends out other people’s money.

Because of that nearly empty vault, there is always a risk the bank has not enough money to fulfill the necessary payments. In such cases, like in today’s credit crisis, they say poetically: the bank has a liquidity problem. More about that later.

Multiply money with the trick with the hat

Our Example Bank, thanks to the deposit of 1,000 euros of John, has created an additional 850 euros to lend out to Peter. Let’s see, what happens to these 850 euros. Peter buys a laptop and the shopkeeper brings the 850 euros to his bank, Bank B. The banker says “thank you” and inscribes the 850 euros on the balance sheet as an asset of the bank. “Banknotes in cash: + 850 euros. But the bank will also have to give the 850 euros back to the shopkeeper one day. So the bank has also a debt to him. The banker writes at the liabilities side: Checking account Computerstore: +850 euros.

Bank B. must keep a cash reserve of at least 10% for the 850 euros that have been added in the checking accounts. That makes 85 euros. So Bank B. can lend out 765 euros. Bank B. lends out 750 euros to William, who buys a bicycle with it. The bicycle seller brings the 750 euros to his bank, Bank C. Of the 750 euros Bank C. can lend out 675 euros. And so the story goes on with each time a bit smaller amounts.

This way John’s banknotes travel consecutively to the Example Bank, to the computer store, to Bank B, to the seller of the bicycle, to Bank C. and so on. And each time a banker gets his fingers on these notes, he can create new loans with them. And finally the 1000 euro’s of john can lead to many loans, spread over many banks, that collect lots of interest with it.

All banks together

If all banks would lend out the maximum allowed, then our Example bank would have lent out 900 euros, the next bank 90% of 900 = 810 euros, the next bank 90% of 810 = 729 euros etc. and all banks together could lend out 9,000 euros with the 1,000 euros of John. Fortunately, until now, banks do not succeed to reach that amount. That would take a lot of time and the average loan does not exist that long. And when a loan is paid back, it disappears from the balance. But even if they succeed in adding only two, three or four times 1,000 euros, they collect two, three or four times as much interest. John himself has a checking account and does not get anything. He even pays costs for checking books and bank cards.

(Note, that the maximum of 9.000 goes for a 10% cash reserve. With a 2% cash reserve the maximum is 49.000!)

Juggling with payments

But if the banks haven’t got the money in the checking accounts, they cannot pay with it, can’t they? Then it isn’t money, is it? That is right. Of the 1,000 euros of John, our Example bank has only 150 euros left and Bank B. has 100 euros left. A bank would never be able to pay the total of all amounts in the checking accounts at once, if the accountholders would order to pay it to accounts at other banks or to hand it out in cash. If the money would really exist, the bank, of course, would be able to. For all the amounts in the checking accounts, the bank has only a little bit of real money, with which it can execute the payment orders of their customers. That is the little bit it did not lend out, the cash reserve.

And when the bank has used that little bit of real money to execute payments for its account holders to account holders at other banks, what happens then?

By that time payments will arrive from account holders from other banks to account holders of our bank. And our bank can use that bit again to execute following payment orders.

So, when John wants to pay 30 euros to someone at another bank, our bank transfers 30 euros from its cash reserve. And then, some other payment will arive from another bank that will increase the cash reserve of our bank again. And this way banks can transfer continuously relatively small amounts to each other. And when they do so quickly enough, a big number of payments can be executed with it.

In fact, it looks as if bankers have an awful lot of money, but in reality it is the little bit from their cashreserves that goes forward and backward between them and with which the payments can be done. But at real banks with thousands of customers that little bit of cashreserve is still a fair amount. With that, substantial amounts can generally be transferred from one bank to another without problems.

Clearing money

Until now we have done all bookings with bank notes. But when banks have to pay each other each time in bank notes, that is not practical. The notes would have to be transported all the time from one bank to another in armoured lorries. That goes in a simpler manner nowadays. Banks can exchange their bank notes for a balance at the central bank. The central bank has accounts of each bank with their balances. And when one bank wants to make a payment to another bank, the central bank transfers it from the balance of that bank to the balance of the other bank.

Because most payments are made through clearing today, banks hold few banknotes and most of their cash reserve consists of a balance at the central bank. And when our Example Bank borrows 50 euros from another bank, these are also added to the cash reserve. (120 + 50 = 170)

And when you borrow money from the bank nowadays, you won’t get bank notes to take home with you, but it is added to your checking account. And as long as you don’t spend that money, it does not lower the bank’s cash reserve. (That only happens at the moment you transfer money to someone who has an account at another bank, or if you withdraw cash money.)


When banks lend out money, they take a risk, that the loan will not be (entirely) paid back. That is why the banks usually ask for a security. When you borrow money for a car, and you don’t pay back, the bank will confiscate the car, sell it and with the product the outstanding loan is paid back. And if that is not suffiscient, you keep a debt towards the bank. But if you cannot pay, the bank has to write off the outstanding amount. And if that happens too often, not only the bank, but also the people who deposited their money, will be in trouble.

Now we come to the second important rule: Banks must have a capital which, at least, equals 8% of the outstanding loans. [4] To put it otherwise: for each 8 euros of capital, the bank may lend out 100 euros. But for some loans, such as loans with mortgages, they may lend out twice as much with the same capital and thus collect twice as much interest. So it is not very surprising that banks like to offer these types of loans. (Although, at the moment, by the end of 2008, loans are a bit problematic.) For loans to the state, the 8% rule does not apply. The state can always raise taxes to pay back the bank.

So, for the loan to Peter, our Example bank has to meet that solvency requirement too. For the loan of 850 euros the bank has to have a capital of 8% of 850 = 68 euros. In our example the bank has 110 euros, so that is suffiscient.

When Peter pays back 100 euros each month, 100 euros are added in the pay-desk (cash) and the amount in Debtors decreases by 100 euros.

But if Peter doesn’t pay back the last 50 euros, then the bank must write them off. Nothing arrives in the pay-desk, but the amount in Debtors will still decrease by 50 euros. And that means, that the total (here 1,130 euros) decreases by 50 euros, and consequently that means that, on the other side, the capital decreases by 50 euros. And if the bank would have had other outstanding loans, then it can easily happen that the bank becomes insuffisciently solvent.

Debit, credit, crisis

That happened in the United States, when especially poorer people had got mortgages at a very low interest, but could not pay anymore when the interest rate went up again. Many bankers had forseen these problems and had insured themselves against defaults of payment. But what these bankers had not count with, is that there would be so many defaulters, that the insurers could not pay anymore and went bankrupt. And so they still had to write off many loans at the assets-side, which decreased their capital at the liabilities side. Their solvency was at stake. Other bankers had sold the risky mortgages in packets to other banks inside and outside the US. The buyers had been fooled and now were stuck with contaminated packets of mortgages, that nobody wanted to buy from them anymore. And this way, world wide, many banks got into troubles and a number of them failed. And because banks did not know of each other who had bought these packets and who might fail the following day, they did not want to lend money to each other anymore. Normally they do so each day, when at the end of the day some have an excess of cash reserve and other are a bit short of it. And when banks do not trust each other, each one has to take care of itself. And that means, take care for suffiscient cash reserve, so, lend out as little as possible. And because most enterprsies depend on loans, the enterprises too get in trouble. In the beginning one by one, and then in increasing numbers. Crisis.

[1] Secrets of money, interest and inflation:

[2] Liquidity requirement Federal Reserve: (since 1992)

[3] Liquidity in Europe, tabel 16

[4] The 8% solvency requirement has been decided by big international banks in the Basel I accords of 1988. Since then it has been reshaped a lot. Since 2006 the Basel II accords are in force, with more requirements for the composition of the capital, but also more choice for bankers to determine the methods of calculating their risks.

The Basel Capital Accords:

Example of calculation of solvency percentage:

European proposal to lower the solvency in 2004:

More documentation:

Bank balance:

Geld, Financiële Markten & Financiële Instellingen, C. van Ewijk & L.J.R. Scholtens (Wolters Noordhoff) (in Dutch.)

December 2008
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