Is a Bank Loan Really a Loan? Credit Creation and Consideration

An argument with a long life in popular legal writing holds that a bank loan is not really a loan. The bank, it is said, does not lend money it already has. It creates the money at the moment of lending, typically by crediting the borrower's account, in exchange for the borrower's signed promise to repay. If the bank gave nothing it previously owned, the argument continues, it gave no consideration, and a contract without consideration is unenforceable.

The first half of that argument is substantially correct and is confirmed by central banks themselves. The second half does not follow from it. Separating the economic description from the legal conclusion is the whole task.

What central banks say about money creation

In 2014 the Bank of England published an article in its Quarterly Bulletin titled "Money creation in the modern economy," by Michael McLeay, Amar Radia and Ryland Thomas. It states plainly: "Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower's bank account, thereby creating new money." It adds that this "differs from the description found in some economics textbooks," which present banks as intermediaries lending out existing deposits.

The Federal Reserve Bank of Chicago's booklet Modern Money Mechanics (1992 revision) described the same process in American terms. Banks, it said, do not lend out the reserves they receive as deposits; "What they do when they make loans is to accept promissory notes in exchange for credits to the borrowers' transaction accounts." Loans, as bank assets, and deposits, as bank liabilities, rise together.

The Bank of England article also describes the reverse: "Just as taking out a new loan creates money, the repayment of bank loans destroys money." And it describes limits on the process, including the bank's need to remain profitable, regulatory requirements, the decisions of borrowers and, ultimately, monetary policy. In the United States, the Federal Reserve reduced reserve requirement ratios to zero effective March 26, 2020, which removed one of the textbook constraints but did not remove the others.

So the popular argument is right about mechanics. A bank making a loan does not hand over a pre-existing pile of depositors' money. It creates a deposit, which is its own liability, and takes the borrower's note, which is the borrower's liability.

What consideration requires

The legal question is different. Consideration, in the common law of contracts, is the bargained-for exchange that makes a promise enforceable. It does not require that the thing given be something the giver previously possessed in physical form, or that it be gold, or that it be anything other than what the parties bargained for.

Where the borrower's promise takes the form of a negotiable note, the Uniform Commercial Code states the rule directly. Section 3-303(b) defines consideration as "any consideration sufficient to support a simple contract," and provides that if an instrument is issued for value as defined in the section, it "is also issued for consideration." An instrument is issued for value, among other things, when it is issued in exchange for a promise of performance to the extent the promise has been performed (§3-303(a)(1)).

In a bank loan, the bank's performance is the credit it extends: the deposit it creates and honors. The borrower can spend that deposit, transfer it, or withdraw it as currency. The bank becomes obligated to the borrower in the amount of the credit at the same moment the borrower becomes obligated to the bank. Each side has given something the other wanted. That is an exchange, whether or not the bank's side of it was money the bank had "before."

How courts have treated the argument

A federal district court addressed a version of the argument in Nixon v. Individual Head of St. Joseph Mortgage Co., 615 F. Supp. 898 (N.D. Ind. 1985). The borrower claimed the mortgage company had lent him "credit or checkbook money" rather than lawful money in gold and silver coin, and that the loan was therefore void. The court rejected the claim. It reasoned that a check "need not be 'legal tender' for a loan to be valid"; that the check functioned as a negotiable instrument and could be converted into Federal Reserve notes; that the constitutional restriction on states making anything but gold and silver coin a tender did not limit private parties; and that "whether money was in the vault or not, the check issued by the Company had the same effect: it allowed Nixon to buy his house."

That decision is a single district court opinion and does not bind other courts. It is cited here because it engages the precise argument and because its reasoning tracks the general law of consideration. The point it makes is functional: the borrower received something he could and did use to acquire property, which is what he bargained for.

The strongest version of the argument

The argument is at its strongest not as a contract defense but as a critique of the monetary system. If private banks create most of the money in circulation by lending, and that money must be repaid with interest, then the power to create money, and the income it produces, rests substantially with private institutions. That is a serious question of political economy, and economists and historians have debated it in many forms. The Bank of England's own article was written partly to correct public misunderstanding of exactly this process.

It is also fair to say that the language of "lending" can mislead. A borrower who imagines that a bank has taken some other customer's savings and handed them over has a mistaken picture of what happened.

But a mistaken picture of the mechanics does not make the bargain void. The borrower agreed to repay in exchange for a deposit he could spend; he received the deposit; he spent it. The question of whether the system that allows banks to create deposits is wise or fair is a question for legislatures and for public debate. It is not a question about whether consideration was present in a particular loan.

What can reasonably be concluded

Banks create deposits when they lend. Central banks say so in their own publications, and the popular argument is correct to insist on it. Consideration does not require the lender to give pre-existing money, however; it requires a bargained-for exchange, and the credit a bank extends is the performance the borrower bargained for. The argument identifies a genuine feature of the monetary system and draws a contractual conclusion that the law of consideration does not support.

For how monetary policy reaches individual borrowers, see the archive's entry on the Federal Reserve and the cost of obligation; for a related claim about signatures and value, see "Accepted for Value": Can a Signature Discharge a Bill?