When most people walk into a bank, they imagine a simple process: depositors put money in, and banks lend that money out to borrowers. But this widely held belief is not how modern banking really works. In fact, what banks do with your money and how they create money is quite different from the story we’ve all been told.

Banks are not just middlemen moving money from savers to borrowers. Instead, they are the actual creators of most of the money supply in circulation. When a bank issues a loan, it doesn’t transfer cash from someone else’s account. It creates a new deposit, money that didn’t exist before, out of nothing.

This process is legal and widely accepted in modern banking systems, including those in the U.S. and U.K. Central banks like the Bank of England have confirmed this, stating that banks create money through lending (see below).

The confusion often starts with the word “deposit.” We assume it means the bank is holding our money in trust. In reality, once you deposit money, it becomes the bank’s property. In exchange, the bank owes you that amount and records it in your account. You haven’t stored money at the bank; you’ve loaned it to them. The bank can then use that promise to pay you back as the basis to create even more money.

This also explains something many people find surprising: how a government can declare a “bank holiday,” temporarily closing banks to prevent panic, and it is completely legal. Since you are legally a creditor to the bank, not someone storing money with them, you don’t have the same rights as someone retrieving something left in safekeeping. The bank owes you money, but it does not have to let you withdraw it at any given moment, especially under emergency rules.

When someone takes out a loan, they sign a contract, often called a promissory note, agreeing to repay the bank. Legally, the bank treats this as the purchase of a financial asset. In response, it credits the borrower’s account with a newly created deposit. No money changes hands. Nothing is taken from another account. The numbers simply appear, and new money is created.

This is not a hidden scheme. It is how the system is designed. The vast majority, about 97 percent, of the money supply exists in the form of bank deposits created this way. The other small fraction comes from physical cash printed by the central bank.

Why does this matter?

Because when banks create new money through lending, it is the primary drivers of inflation. With more money chasing the same amount of goods and services, prices rise, a connection often overlooked due to public misunderstanding of how money is created. This is why central banks say they monitor and attempt to influence lending activity. Excessive money creation, particularly in a growing economy, devalues the currency and increases the cost of living.

But not everyone feels this equally. The Cantillon Effect explains how those closest to the source of new money, such as banks, large corporations, and asset holders, benefit first as they can spend before prices rise. Meanwhile, wage earners and those on fixed incomes face higher costs without seeing the same early benefit. In short, inflation caused by money creation does not just make things more expensive, it redistributes wealth upward in an economy built on this system.

So, while the average person tends to associate credit with things like car loans or credit cards, the reality is that the entire economy runs on debt. The largest borrowers are corporations, financial institutions, and governments, which use credit to purchase assets, expand operations, and leverage growth. These entities often access this new money at scale and at much lower interest rates, allowing them to benefit early, while everyday consumers feel the effects later in the form of rising prices and shrinking purchasing power.

This ability to expand the money supply is a powerful function granted to the banking sector by law and while it plays a central role in supporting economic activity, it also has direct consequences that affect everyone, especially those furthest from the source of new money.

Understanding this shifts how we think about debt, the role of banks, and the flow of money through the economy. It also raises questions about transparency and regulation. If most people believe banks are lending out savings, when in fact banks are creating money through accounting entries, it is worth asking whether customers are being fully informed, even unintentionally.

For more information on how banks create money, see:

The following resources include both U.K. and U.S. central bank publications, since the principles of money creation apply broadly across all economies using fractional reserve banking systems.

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