Money Creation and Destruction

When you take out a loan, here's what happens:

1. Let's say that a bank's first and only deposit is $1000 cash. That cash becomes "reserves." 90% of that amount becomes "excess reserves." Banks can only create new loans when they have excess reserves available.

2. A potential borrower comes to the bank, and puts up some form of collateral, such the deed to their house or car. The maximum amount they can borrow is equal to the bank's excess reserves ($900 in this case).

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3. The borrower signs a note, which is a promise to back the loan within a certain time at a certain interest. The collateral is held by the bank in case the borrower defaults.

4. When the loan is funded, the proceeds are credited to the borrower's account. However, a very important point here: the loan is not funded from the bank's reserves. It is funded by creating new money, just for that purpose. As with all accounting transactions, there are two sides to this one. The other side in this case is the creation of an asset with the same value as the money created. That asset is the note.

5. The borrower makes payments on the loan. Interest goes to the bank as income, which they can then use to cover their expenses or to pay out to shareholders, as any company would. Principal goes to pay down the note. Banks don't just keep that money around and re-lend it at a later time. The money is destroyed when it's paid back, and then re-created later if/when needed for a new loan.

6. If the borrower defaults, then when the loss is recognized, the collateral is sold. If the collateral is worth less than the remaining value of the note, the difference is written off against bank earnings. In effect, the money representing bank earnings is destroyed. This happens because although banks can create money, they can't create their own earnings, and they are required to accept the consequences of making loans that don't get paid back (well, at least that's the theory, until gov gets involved via the FDIC, the Fed, TARP, etc).

Here's a video I made that gives a high-level view of the process:

http://www.youtube.com/watch?v=xNehYxy77RI