This blog post calmly examines the structure and underlying premise of how banks create credit not with their own money but based on depositors’ assets, generating profits through loans and interest.

The money lent out isn’t in the bank

The ‘reserve requirement ratio’ refers to a system where banks are required to keep only a certain percentage of total deposits on hand, allowing them to lend out the remainder. For example, if the reserve ratio is 10%, the bank can hold only 10% of the deposits and lend out the remaining 90%. However, for this system to function, another crucial premise is necessary: ‘Most people do not withdraw all the money they have deposited in the bank at once.’ Let’s hear an explanation from Jeffrey Myron, a professor of economics at Harvard University, regarding this.

“If everyone decides to withdraw all their deposits on the same day, the bank will inevitably go bankrupt. This is because the cash the bank holds falls far short of 100% of the deposits. This is precisely what happens during a financial crisis. People who have deposited money in various financial institutions simultaneously try to withdraw it. However, banks and other financial institutions do not hold all that money. The funds have already been invested in various sectors of the economy. Therefore, if everyone tries to withdraw their deposits at once, the financial institution in question will inevitably collapse.”

To help understand this better, let’s consider an example. Suppose a total of 10 million won is deposited in Bank A. Ten people own this money, each having deposited 1 million won with the bank. Following the reserve requirement ratio, the bank keeps only 1 million won of the total 10 million won deposit, having already lent out the remaining 9 million won. This operation is based on the experience that depositors typically use amounts around 100,000 won rather than withdrawing the full 1 million won all at once. It is also a judgment based on the assumption that all 10 depositors would not simultaneously visit the bank to withdraw their entire 1 million won each, totaling 10 million won, all at once.
But what if, one day, all ten of these people came to the bank simultaneously to withdraw their entire 1 million won deposits? The bank holds only 1 million won in cash, so it has no money to pay the remaining nine people. Ultimately, the bank becomes insolvent and goes bankrupt. This phenomenon is called a ‘bank run’.
Theoretically, if ‘every single person’ who deposited money with the bank attempts to withdraw their deposits ‘simultaneously,’ the bank would immediately go bankrupt. This bank run is precisely the situation banks fear most. However, banks don’t typically worry about this scenario under normal circumstances because such events rarely occur unless the bank is in a severely distressed state. Therefore, whenever incidents like the 2008 Lehman Brothers bankruptcy during the U.S. financial crisis or the 2011 suspension of operations at Korean savings banks occur, it is not unreasonable for the greed and moral hazard of the financial sector—which brought the crisis upon itself through reckless sales of loan products—to be discussed alongside the events.

The Story of the Goldsmiths Who Became Bankers

Understanding this structure is greatly aided by the story of the English goldsmiths, often cited as the origin of banking. Canadian economist Charles Nelson details this anecdote in his book Macroeconomics. Here, we’ll examine the origins of banking through the explanation of Ellen Brown, president of the Public Bank Institute.

“This story begins with the 17th-century English practice of depositing gold with goldsmiths for safekeeping. Goldsmiths issued paper receipts for deposited gold, and those who issued these receipts later became bankers. These receipts would later be called ‘bank notes.’ They served as proof of the deposited gold. Both those seeking to borrow gold and those depositing it preferred these paper receipts. They were easy to carry and less prone to theft.”

Such practices were common in 17th-century English cities. At that time, there was no universal currency system like today’s; gold itself was the currency. However, gold was heavy and inconvenient to carry. Therefore, people melted gold to make gold coins, which began to be used as a common medium of exchange. But keeping expensive gold coins at home or always carrying them on one’s person was also dangerous. Eventually, people began using goldsmiths’ vaults to store their gold more securely. Goldsmiths possessed large, sturdy vaults, which were the safest storage places in town.
When people deposited gold coins with the goldsmith, he would issue a receipt and promise to return the gold whenever the receipt was presented. Naturally, he charged a storage fee for this service. But at some point, people began exchanging the gold receipts instead of the coins themselves. Not only were the certificates much lighter and easier to carry than gold, but they could be exchanged back into gold coins anytime simply by bringing them to the goldsmith. Thus, the gold certificates temporarily took on the role of currency.
Observing this situation, the goldsmith gradually realized an interesting fact: people did not come to retrieve all the gold coins they had deposited at once, and it was rare for many people to come at the same time. After this realization, the goldsmith began to exercise ‘ingenuity’. He decided to lend out the gold coins entrusted to him to others and receive interest in return. He reasoned that as long as the loans were repaid normally, the people who had deposited their gold would not notice, and he could earn profit at almost no cost.
However, this truth could not be hidden forever. When the goldsmith suddenly began making large sums of money, people started to find it suspicious. Eventually, they discovered he was lending out the gold they had entrusted to him, collecting interest, and profiting from it. The enraged people flocked to the goldsmith to protest. Then, the goldsmith once again showed his ingenuity and made this proposal:

“I’ll share a portion of the interest I earn from lending out your gold.”

This proposal easily swayed the people. The idea of earning money without lifting a finger was highly appealing. Even if he shared the interest, the goldsmith felt little burden, since he was earning interest on other people’s money anyway. Then, he began to grow increasingly greedy. He realized that no one knew exactly how much gold was actually in his vault. Eventually, he began to pretend that gold existed in his vault that wasn’t there, freely issuing gold certificates. Of course, people had no idea he was ‘creating’ money that didn’t exist in his vault.
Ellen Brown explains this as follows.

“Goldsmiths issued certificates worth about ten times the gold they actually held. They knew people typically only came to withdraw about 10% of the total gold. This became the basis for today’s 10% reserve requirement. And this structure hasn’t changed much since then.”

In this way, goldsmiths accumulated immense wealth by charging interest even on non-existent gold, eventually transforming into bankers. Later, when some wealthy depositors grew suspicious and withdrew all their gold, triggering a bank run, this crisis became another opportunity for the bankers. It was the British monarchy that extended the ‘lifeline’ at this time. Needing war funds, the British Crown granted bankers the ‘authority to create and lend virtual money.’ The word ‘Chartered,’ commonly found in bank names, signifies precisely this ‘license’ and ‘official recognition.’ In other words, it meant they received permission from the government to issue virtual money.
The British Crown permitted loans up to approximately three times its gold reserves at the time, and it was then that the close relationship between banks and the government truly began to take shape. Jeffrey Ingham, Professor of Sociology at the University of Cambridge, explains this as follows:

“The Bank of England was established in the late 17th century. London merchants provided the capital. This was a transaction between the king and the merchants. The king needed war funds, and the merchants hoped the war would secure trade routes and expand territories. These interests aligned. Ultimately, the merchants gained the authority to establish the Bank of England and enjoyed special royal permission and privileges. The merchants raised £2 million to lend to the king, and these bonds became the bank’s assets. Using these assets as collateral, the bank then issued £2 million in banknotes. The value of these notes was based on the king’s promise to repay the money. This is the very essence of banking.”

Banks that make money with other people’s money

Through this process, the modern bank was born. Banks gained the ability to operate money they didn’t actually hold, within the limits permitted by the government, through the reserve requirement system. This structure remains unchanged in today’s banking system.
In fact, the bank’s business model is highly unique. Most businesses sell existing goods or services. That is, they presuppose tangible goods that have been made or services that can be provided. But banks are different. Banks sell ‘what does not exist’. They create virtual money and lend it out to gain real-world profits.
Ellen Brown states the following about this:

“Banks don’t lend out deposits as they are. Banks don’t say, ‘We’ve already lent your deposit to someone else, so come back in 30 years’. Instead, banks claim, ‘We don’t hold all the actual money, but we can pay you back immediately whenever you want.’”

The reason banks can operate this way is also because, through long experience, they know ‘not all depositors will withdraw their money at the same time.’ American financial historian John Steele Gordon succinctly summarizes this as follows.

”Banks make money with other people’s money.”

Ultimately, banks are organizations that create new money based not on their own capital, but on other people’s money, and survive by charging interest on it. This is also the fundamental reason why our society today has become a ‘debt-promoting society’. The loan text messages that arrive several times a day and the endless stream of loan offers are proof of this. Because every time a customer takes out a loan, new money is created for the bank.