Here is a quick post from John K Ellis, J.D. of Goodman Law Center
HOW BANKS WORK
Here is how I always thought that a private bank worked: A group of enterprising young businessmen (would-be bankers) get together and put up a bunch of money (capital) in order to start a bank. The bank then entices bank customers (depositors) to invest their money in the bank by offering them checking and savings accounts, and by paying them a small rate of interest on the money that they have invested in the bank. The bank then turns around and loans out its net surplus deposits to other bank customers (borrowers) at a modest rate of interest. Thus, the bank eventually will make a profit, measured by the difference between the modest rate of interest collected from its borrowers and the small rate of interest paid to its depositors.
Believe it or not, this is not at all how most private banks work. Private banks generally do not loan out any depositor funds when they make loans to people. To the contrary, when a private bank lends you money, the bank simply makes two offsetting accounting entries on its books. The bank simultaneously credits your account by the amount of your new loan (so that the loan proceeds mysteriously show up in your bank account), and then the bank effectively debits your account on its books by the amount of the promissory note you had to give to the bank in order to get your loan. By doing so, the bank essentially has “monetized” your promise to pay back the money you borrowed from the bank. No depositor funds are involved. In this way, the bank has “manufactured” this money “out of thin air,” as it were. And yet, if you miss a couple payments on your loan to the bank, the bank will foreclose upon the collateral that you were required to put up in order to get your loan from the bank.