Shrinking Balance Sheets
When banks make loans, new money is created in the form of entries in somebody’s bank account. What happens when these loans are repaid? Exactly the opposite – money is destroyed.
Continuing with the example of Robert from How Commercial Banks Create Money and How Payments Are Made, Robert borrowed $10,000 to buy a car. Let’s imagine that he now wishes to repay this loan. (To keep this example simple, we will imagine the loan being repaid in one lump sum, rather than in installments, as is usually the case.)
Recall the situation directly after Robert buys his car. the bank has an asset of $10,000, which is its loan to Robert, and shareholder equity totalling the same amount. Robert has a debt to his bank of $10,000.
After working for a few months Robert is paid $11,000 by his employer. This payment is made from Robert’s employer’s bank account to Robert’s account electronically – BOA gains an asset ($11,000 in reserves) and so increases Robert’s account by the same amount.
Robert decides to use the $11,000 to repay his loan in full, with interest. With an interest rate of 10% on the loan, Robert owes $11,000 in total, $1,000 of which is interest. Robert informs BOA that he wishes to repay the loan in full, plus interest owed. From Robert’s perspective, he sees that the $11,000 is ‘taken out’ of his account by BOA. However, in reality, no money is moved at all. BOA simply decreases its liability to Robert (i.e. his bank balance) by $11,000, and simultaneously removes the $10,000 loan from its assets because the loan has been repaid.
Robert now has no money in his bank account (BOA’s liability to him is zero). He also has no debt. BOA’s assets have increased from $10,000, when they made the loan, to $11,000 now that the loan has been repaid. However, BOA’s equity has also increased from $10,000 to $11,000. As a result, if the bank were to now close down and sell off all their assets and settle all their liabilities, the shareholders would have $1,000 more than they had before the loan was made – this is their profit.