Bank of England Quarterly Bulletin 2014 Q1

bank deposits are mostly created by commercial banks 
themselves
. Although the stock of bank deposits increases 
whenever someone pays banknotes into their account, the 
amount of bank deposits is also reduced any time anyone 
makes a withdrawal. Moreover, as 
Chart 1 
shows, the 
amount of currency is very small compared to the amount of 
bank deposits. Far more important for the creation of bank 
deposits is the act of making new loans by banks. When a 
bank makes a loan to one of its customers it simply credits 
the customer’s account with a higher deposit balance. 
At that instant, new money is created. 
Banks can create new money because bank deposits are 
just IOUs of the bank; banks’ ability to create IOUs is no 
different to anyone else in the economy. When the bank 
makes a loan, the borrower has also created an IOU of their 
own to the bank. The only difference is that for the reasons 
discussed earlier, the bank’s IOU (the deposit) is widely 
accepted as a medium of exchange — it is money. 
Commercial banks’ ability to create money is not without 
limit, though. The amount of money they can create is 
influenced by a range of factors, not least the monetary, 
financial stability and regulatory policies of the Bank of 
England. These limits, and the money creation process 
more generally, are discussed in detail in the companion 
piece to this article. 
(iii) Central bank reserves 
Commercial banks need to hold some currency to meet 
frequent deposit withdrawals and other outflows. But to 
use physical banknotes to carry out the large volume of 
transactions they do with each other would be extremely 
cumbersome. So banks are allowed to hold a different type 
of IOU from the Bank of England, known as 
central bank 
reserves 
and shown in green in