How do banks make money? Secrets they don't tell you
Aug 21, 2025
7 min read
Article
If you’ve ever wondered how do banks make money, you’re not alone. For many people, the idea that commercial banks “create money” feels counterintuitive. Isn’t money printed by governments and central banks like the RBI or the Federal Reserve?
The surprising truth is that most modern money isn’t printed at all. Instead, it’s created when banks issue loans. Every time a bank approves a loan, new purchasing power enters the economy. This process explains both the incredible growth potential of banking and the recurring financial crises we see worldwide.
In this article, we’ll break down how banks create money, why they can’t lend infinitely, and what happens when things go wrong. By the end, you’ll see why understanding this mechanism is crucial for grasping both prosperity and collapse in today’s financial system.
How Do Banks Make Money
Most people think banks simply earn by keeping deposits and lending them out. But the truth is far more fascinating: banks actually create new money when they issue loans.
When you take a loan of ₹1,00,000, the bank doesn’t physically give you someone else’s deposit. Instead, it simply credits your account with that amount. From your perspective, you now have new money to spend. On the bank’s balance sheet, the loan is recorded as an asset (what you owe them), and your deposit becomes a liability (what they owe you).
This accounting trick means that new money has just been created — not printed, but digitally generated. Economists call this process credit creation.(Bank of England)
As John Maynard Keynes once noted:
“When banks extend credit, that is, create deposits for their customers, they create money.”
In fact, the majority of money circulating in the modern economy exists only as numbers in bank accounts. Cash in your wallet is just a small fraction.
Fractional Lending and the Multiplier Effect
So, how do banks make a profit from this system? The answer lies in fractional lending. Banks keep only a fraction of deposits as reserves while lending out the rest. This allows them to charge interest on loans, which becomes their primary source of income.
Here’s a simple example:
You deposit ₹10,000.
The bank keeps ₹1,000 as reserves and lends out ₹9,000.
That ₹9,000 ends up in another account, and 90% of it is lent again.
This cycle repeats, multiplying the amount of money in circulation.
Banks profit through interest spreads — the difference between what they pay depositors and what they charge borrowers. Other income sources include service fees, trading, and investments, but lending remains their core business.
What Keeps Banks From Creating Infinite Money?
If banks can create money through loans, why don’t they just lend endlessly? The system has checks and balances:
Capital Adequacy Rules – Banks must hold a minimum level of their own capital relative to risk-weighted assets.
Reserve Requirements – They must keep a portion of deposits with the central bank.
Default Risk – If too many borrowers fail to repay, banks face losses.
Central Bank Oversight – Regulators like the RBI and the Federal Reserve supervise lending practices.
Market Trust – If customers lose faith, they may withdraw deposits, sparking a liquidity crisis.
These safeguards ensure stability — but when ignored, the entire system becomes fragile.
What Happens When Borrowers Don’t Pay?
When loans go unpaid, they turn into Non-Performing Assets (NPAs). A few NPAs are manageable, but systemic defaults can trigger widespread panic. Banks, being cautious, then reduce lending, which slows down economic activity.
This credit contraction is one of the fastest ways economies slip into recession.
The 2008 Financial Crisis: A Case Study
The 2008 Global Financial Crisis is the clearest example of what happens when banks take lending too far. In the early 2000s, American banks were on a lending spree. They offered subprime mortgages — home loans for people with weak credit scores — under the belief that housing prices would keep rising forever.
But the story didn’t stop there. These risky loans were then packaged into complex securities and sold across the globe, spreading the risk far and wide. For a while, it looked like everyone was winning: borrowers bought homes, banks collected fees, and investors earned returns.
Then came the turning point. Housing prices began to fall. Suddenly, millions of borrowers could no longer repay their mortgages. As defaults piled up, the supposedly “safe” securities lost value overnight.
What followed was a collapse of trust. Banks, unsure of who was holding toxic assets, stopped lending to one another. Credit — the lifeblood of the economy — froze.
The ripple effects were devastating. Stock markets crashed, businesses folded, unemployment surged, and governments around the world had to step in with emergency bailouts.
The crisis exposed a harsh truth: while banks create money through lending, they can just as easily destroy confidence when risk management fails.
Why Crises Still Happen Today
Even after 2008, banking remains inherently cyclical. As long as growth depends on lending, risks of overconfidence and mismanagement remain.
Cheap credit can inflate bubbles.
Loose lending standards lead to fragile borrowers.
Global interconnections mean one country’s crisis can spread worldwide.
The system thrives on balance: banks must create money to fuel growth but avoid reckless behavior that plants the seeds of collapse.
Final Thoughts
So, how do banks make money? By creating credit — the lifeblood of modern economies.
They don’t just shuffle deposits; they create new money when they lend.
Regulations, reserves, and oversight keep the system in check.
When lending turns reckless, crises like 2008 remind us of the risks.
Banks are both engines of growth and sources of fragility. Understanding their role helps us see the balance between prosperity and risk in the global financial system.
FAQs
1. Where do banks get the money to lend?
Banks don’t “use up” deposits. They create new money by issuing loans, backed by trust, reserves, and regulations.
2. Do banks print money?
No. Only central banks print physical currency. Commercial banks create money digitally through credit creation.
3. How do banks make a profit?
Primarily through interest on loans, along with fees and investments.
4. How does the RBI (or FED) create money?
Central banks create base money by printing currency or buying assets. Commercial banks then multiply this base money through lending.
5. How do commercial banks generate income compared to central banks?
Commercial banks earn profit from lending and fees, while central banks operate to stabilize inflation, currency, and economic growth.
Related Articles
