How deposits become loans

The common picture: savers deposit money, the bank keeps a fraction, and lends the rest to borrowers. Money moves from saver to borrower through the bank.

That picture is wrong about the direction, and the correct version matters for understanding both credit cycles and monetary policy.

What actually happens

Work the problem. A bank approves a ₹50 lakh home loan and disburses it.

	Debit	Credit
Loan to customer (asset)	50,00,000
Customer's deposit account (liability)		50,00,000

Both entries are on the bank's own books. The bank's assets rose by ₹50 lakh and so did its liabilities. Nothing was taken from any other depositor's account.

So where did the deposit come from? The loan created it. The borrower now has ₹50 lakh in their account that did not exist a moment earlier, and an obligation of ₹50 lakh to the bank.

This is chapter 3 of the Accounting subject's double entry, applied to the one business where it produces a surprising conclusion: lending creates deposits rather than spending them.

Why the usual story feels right anyway

Because for a single bank it nearly is. When the borrower pays the seller of the house, and the seller banks elsewhere, our bank must settle — and it needs reserves or funding to do so. From one bank's seat, lending does feel like it consumes money.

For the system as a whole it does not. The deposit simply moves to another bank, where it is still a deposit. Money is not destroyed by being spent; it changes hands.

Both views are correct at their own level, and conflating them is the usual source of confusion.

What actually constrains lending

If a bank can create a deposit by lending, what stops it lending without limit? Four things, in roughly the order they bind:

Creditworthy demand. The binding constraint most of the time. A bank cannot lend to people who will not repay without eventually recognising the loss — chapter 4. In a downturn, the shortage is of borrowers worth lending to, not of money to lend.

Capital. Every loan must be backed by equity sufficient to absorb its potential losses. This is the hard regulatory limit and the subject of chapter 3.

Liquidity and reserves. The bank must settle when money leaves. The cash reserve ratio requires a share of deposits to sit with the RBI, and the statutory liquidity ratio a minimum holding of liquid assets. Both raise the cost of expanding the balance sheet.

The price of funds. Expanding faster than deposits grow means buying funding in the market, at a rate the RBI's policy decisions influence — chapters 6 and 7.

Notice what is not on the list: a pile of pre-existing savings waiting to be lent out. That is the part of the textbook picture that does not survive.

Why this matters beyond the accounting

Three consequences worth carrying.

Credit is pro-cyclical. When times are good, borrowers look creditworthy, collateral is valuable, and capital is ample — so lending expands, which makes times better, which makes borrowers look more creditworthy. The reverse is just as self-reinforcing. Nothing in the mechanism is stabilising.

Monetary policy works on price and willingness, not on a quantity of money. The RBI does not hand banks money to lend. It changes the rate at which banks fund themselves and the conditions under which they operate, and lending responds. Chapter 7 traces that path.

Most money in the economy is bank deposits, created by lending — not currency printed by anybody. Chapter 10 puts numbers on that.

The point

A loan creates a deposit: the bank writes an asset and a liability on its own books, and nothing is taken from another saver. For one bank the old story nearly holds, because the deposit soon leaves; for the system it does not, because the deposit simply moves. What limits lending is creditworthy demand, capital, liquidity requirements and the cost of funds — not a stock of savings waiting to be lent.