Banks: The Hidden Core of the Financial System

Banks are usually pictured as intermediaries: households deposit money, banks collect it and lend it to firms and other households. The picture is intuitive but incomplete. Modern commercial banks create deposits when they lend. They operate balance sheets that connect households, firms, governments, financial markets and the central bank. They provide payment services, transform maturities and liquidity, assess credit risk, and create and distribute financial claims.

Because bank deposits make up a large part of the money used in daily economic life, banking is embedded in the monetary system itself. The banking system is, simultaneously, a credit system, a payments system and a money-creation system, which is what distinguishes banks from other financial intermediaries. This lesson builds on Lesson 2 (what money is) and Lesson 3 (how credit brings the future into the present).

The textbook sequence runs from depositor to bank to borrower: a saver deposits, the bank lends the deposit on, the borrower spends. It contains some truth, because banks need stable funding and liquidity, but it does not describe the accounting of modern lending. According to the Bank of England’s analysis, when a bank makes a loan it credits the borrower’s account with a new deposit; the bank does not need to take existing cash from another customer first. For a €100,000 loan the bank records:

The bank has created a financial asset and a financial liability at the same moment, and the borrower now holds a deposit that can be used for payments. This is why money and credit are so closely connected.

The mechanics are easiest to follow on a balance sheet, which is a highly leveraged structure that connects several layers of the financial system, rather than a vault containing money.

A customer who sees €20,000 in an account thinks of it as money, which it is. From the bank’s side the same €20,000 is a liability. The deposit is an asset of the customer and a liability of the bank. It is not an object stored inside the bank but a contractual claim recorded on its balance sheet, so the money used by households and firms is often, at the same time, a liability of a commercial bank.

If a customer pays another customer of the same bank, the bank adjusts its own records. If the payment goes to an account at a different bank, the two banks must settle, and settlement takes place in central-bank money. Commercial banks hold reserve accounts at the central bank, and a payment between banks moves reserves between those accounts. Take a €10 million payment from a customer of Bank A to a customer of Bank B.

The structure is a hierarchy: households and firms hold deposits at commercial banks, and commercial banks hold reserves at the central bank. Deposits are liabilities of commercial banks; reserves and currency are liabilities of the central bank, which therefore sits at the settlement core of the system.

That a bank can create a deposit when it lends does not mean it can create unlimited money. A bank has to weigh borrower creditworthiness, expected losses, profitability, capital and liquidity requirements, funding conditions, collateral, interest-rate risk, regulation, internal risk limits and the demand for credit. Every loan creates an asset that can lose value if the borrower defaults. A bank can therefore create a deposit, but not an unlimited quantity of safe, profitable and capital-efficient assets.

The Bank of England’s analysis adds that, in normal conditions, the central bank supplies the reserves the system needs at its policy rate. For that reason the binding constraints are the bank’s profitability and risk appetite, its regulatory capital and the demand for credit at prevailing rates, with the policy rate as the principal influence. The banking system creates money through credit, but the sustainability of that creation depends on the quality of the balance sheets behind it.

Capital is the buffer that absorbs losses. The balance-sheet identity is simple: assets equal liabilities plus equity. If asset values fall while liabilities stay fixed, equity takes the loss, and a large enough loss threatens solvency.

Leverage raises returns on equity in good times and magnifies losses in bad times. A small deterioration in a large loan book can therefore have a large effect on capital, which is why banking crises can become systemic and why capital requirements exist. Rapid lending growth may raise profits during an expansion, but if underwriting standards weaken it also raises future losses.

Two precautions about measurement. Regulatory capital ratios such as Common Equity Tier 1 (CET1) divide capital by risk-weighted assets, whereas a leverage ratio divides it by total exposures without risk weights; the two answer different questions. And a high ratio today says little about how a loan book will perform under stress, which is why the questions in the framework below matter.

A bank may be solvent but temporarily illiquid: it owns valuable assets and has adequate capital, but lacks immediately available funds to meet withdrawals or payments. Conversely, a bank may have access to liquidity while its assets deteriorate so far that its capital becomes inadequate. The distinction explains much of what central banks do.

It also follows from maturity and liquidity transformation. Customer deposits can be withdrawn or transferred quickly, while loans may mature over years, so a bank holds relatively illiquid assets and issues relatively liquid liabilities. This is economically useful and also a source of vulnerability. If confidence falls and many depositors or counterparties ask for liquidity at once, a bank can come under pressure even if most of its assets remain fundamentally sound.

A run reflects the structure of banking and not only nervousness. Deposits are short-term, liquid claims; loans are often long-term and comparatively illiquid. If depositors demand repayment together, the bank cannot sell every loan immediately at full value. It needs liquid assets, access to wholesale funding, central-bank liquidity or emergency asset sales. If many banks face the same problem, the issue becomes systemic, and the liquidity problem interacts with asset prices.

When a bank creates a €100,000 loan it creates €100,000 of assets and €100,000 of liabilities for itself, and so expands the stock of financial claims. It does not create €100,000 of net financial wealth for the economy, because the borrower’s new asset, the deposit, is matched by the borrower’s new liability, the loan. For the private sector as a whole, one claim is offset by an obligation.

This is the difference between money creation and wealth creation. Real wealth consists of productive businesses, factories, infrastructure, technology, housing, natural resources and human capacity. Financial assets are claims on income, assets or future payments. Banks can create claims, but they cannot create productive capacity through accounting entries. If credit finances productive investment, the resulting capital can raise the economy’s capacity to produce, and that is the link between finance and real wealth. Money creation in itself is not wealth creation.

Repayment reverses the original expansion. When a borrower repays €100,000 of principal, the bank’s loan asset falls by €100,000 and so does the borrower’s deposit. Lending creates deposits and repayment removes them, so credit growth and deposit growth move together. In a rapid credit expansion deposits can grow quickly; in a period of deleveraging, credit growth can slow sharply or turn negative, and the monetary environment changes with the credit cycle described in Lesson 3.

The two institutions perform different functions, and the relationship between them is hierarchical. The central bank does not “lend money to banks” in the way a bank lends to a household; it provides the ultimate settlement asset and influences the financial conditions in which banks operate.

It is commonly assumed that when a central bank expands its balance sheet, households receive more money in their accounts. That is not how the system works. When a central bank buys an asset from a commercial bank, the bank’s reserves rise and the asset leaves its balance sheet: the reserves stay within the banking system and are not a household deposit. As Lesson 2 noted, if the seller is a non-bank investor such as a pension fund, the seller’s bank is credited with reserves and the seller’s deposit rises as well. Even then the central bank does not credit households at large.

Quantitative easing therefore operates first through the balance sheets of financial institutions and the central bank. Its wider effects run through lower yields, portfolio rebalancing, asset prices, financing conditions, expectations, exchange rates and credit conditions, and the transmission to households and firms is indirect. These channels are examined in Part II.

In stress, a central bank can, within its legal framework, provide emergency liquidity to banks against eligible collateral. This function, classically associated with Walter Bagehot, is the lender of last resort. Its purpose is not to guarantee that every bank survives but to stop a temporary liquidity problem from becoming a disorderly systemic failure.

The liquidity–solvency distinction sets its limit. A central bank can supply liquidity, but it cannot repair fundamental insolvency by creating more reserves: if a bank’s assets are worth substantially less than its liabilities, the problem is capital. Banking crises therefore often require a combination of central-bank liquidity, capital restoration, restructuring, resolution mechanisms, deposit protection, and where appropriate fiscal support. Monetary liquidity alone cannot repair every balance sheet.

Banks are one of the main channels through which monetary policy reaches the economy. When the central bank changes its policy rate, banks are affected through funding costs, market rates, deposit pricing, asset valuations and expectations. They adjust lending and deposit conditions, borrowers respond, property and financial markets reprice, and spending and investment change.

Banks sit at the centre of the credit cycle described in Lesson 3. In a favourable phase, strong growth raises confidence, collateral strengthens, perceived risk falls, lending increases and spending supports growth. In a downturn, weaker growth lowers collateral values, perceived risk rises, lending tightens and spending falls. Banks can therefore amplify economic cycles. That does not make them the source of every instability: they respond to the incentives and risks they face. But because of their position in the network, a change in bank lending affects corporate investment, housing demand, household consumption, asset prices, employment, government revenue and financial markets. Bank credit is a macroeconomic variable.

Profitability gets attention, but for the economy the structure of the balance sheet is often more informative. A bank can be very profitable during a credit boom while accumulating risks that only appear when conditions change. The balance sheet is a window into the future.

The euro-area aggregate shows why both views are needed. According to the ECB, the significant institutions it supervises directly had, in the second quarter of 2026, an aggregate CET1 ratio of 16.00%, a total capital ratio of 20.13%, a liquidity coverage ratio of 154.91% and an annualised return on equity of 10.73%, the highest since the series began in 2015. These figures describe the resilience and earnings of the sector in aggregate; they do not by themselves say how any individual bank’s loan book would behave under stress.

A commercial bank is connected to almost every component of the economy: households (deposits, mortgages, payments), companies (loans, working capital, payment services), governments (securities, public-sector deposits and financing), other banks (interbank markets, correspondent banking, settlement), central banks (reserves, policy operations, liquidity facilities), financial markets (issuance, trading, collateral, funding) and foreign institutions (cross-border payments, foreign exchange, international lending).

A shock can therefore travel along the network: a property decline weakens households, household weakness raises mortgage losses, mortgage losses weaken banks, weaker banks lend less, reduced lending weakens firms, and weaker firms cut jobs and pay less tax. The initial shock becomes a macroeconomic event.

If a manufacturing company fails, the consequences fall on its employees, creditors and suppliers. If a major bank fails, they can extend across the financial system, because banks provide money, credit, payments, liquidity transformation, settlement and market-making. A disruption to those functions affects activity almost immediately. That is why systemic banking instability has historically been treated differently from ordinary corporate failure, and why regulation focuses on capital, liquidity, risk management, resolution planning and systemic resilience.

The objective of regulation is not to eliminate financial risk, which is impossible. It is to prevent the failure of one institution or one segment from becoming an uncontrolled breakdown of the wider economy.

Banks are better understood as institutions that transform balance sheets than as simple intermediaries. They transform deposits into credit relationships, short-term liabilities into longer-term assets, central-bank money into a wider system of bank money, individual savings and payments into a network of claims, and credit risk into diversified exposures.

This creates economic value and creates vulnerability, because every transformation introduces a mismatch: of maturity, of liquidity, of credit risk, of interest rates, of currency or with a counterparty. Banks exist partly because the transformations are useful; financial regulation exists partly because they can become dangerous.

1. Lesson 1 — Modern financial capitalism — The economy is a network of interconnected balance sheets.
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2. Lesson 2 — Money — Money comprises central-bank money and commercial-bank deposits.
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3. Lesson 3 — Creditism — Credit brings purchasing power forward from the future and creates financial obligations.
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4. Lesson 4 — Banks — Commercial banks sit at the centre of the mechanism that links money, credit and balance sheets.

The architecture can be drawn from the central bank down to the real economy: the central bank supplies reserves to commercial banks, which create deposits and credit for households and companies, which consume, invest and make payments in the real economy. The arrows run in both directions. The real economy generates income, income services debt, debt service supports bank assets, bank assets support bank balance sheets, bank balance sheets determine credit capacity, and credit conditions shape future activity. The system is circular, not linear.

• Douglas Diamond and Philip Dybvig, “Bank Runs, Deposit Insurance, and Liquidity”, Journal of Political Economy, 1983.
• Walter Bagehot, Lombard Street: A Description of the Money Market, 1873.
• Perry Mehrling, The New Lombard Street, and Ulrich Bindseil and Alessio Fotia, Introduction to Central Banking, both in the Reading Room.