Money Creation Through Investment — Not Just Lending#

Most conversations about money creation start and stop with lending. A bank makes a loan, a deposit appears, new money enters the economy. The mechanism is elegant, well-documented, and by now familiar. But it tells only half the story. There’s a second road to the same destination — one that gets far less airtime despite producing identical results on a bank’s balance sheet.

When a commercial bank buys a security, it creates money.

The Cognitive Gap#

Textbooks pour chapters into the lending channel. The sequence feels natural: a borrower needs funds, a bank sizes up the risk, approves the loan, credits the account. New deposit, new money. The story has a protagonist (the borrower), a clear action (the loan), and a satisfying outcome (the deposit).

The investment channel has none of that narrative tidiness. No borrower walks through the door. No loan officer weighs the risks. Instead, a bank’s treasury desk decides to buy government bonds or other eligible securities on the open market. On the surface it looks like an ordinary asset swap — bonds for cash. But the monetary consequences run deep.

This gap in awareness matters because the investment channel accounts for a substantial share of deposit creation in modern economies. Central bank policies like quantitative easing run almost entirely through this channel. Grasping money creation without grasping investment-based creation is like understanding an engine while ignoring half its cylinders.

The Investment Process: Step by Step#

Say a commercial bank, National Bank, has $500,000 in excess reserves. Its investment committee spots $500,000 in U.S. Treasury bonds offered by a pension fund that banks at Regional Bank.

National Bank buys the bonds. How does it pay?

Not with physical cash. Not with a check drawn on some external account. The transaction settles through the reserve system. National Bank’s reserves at the Federal Reserve fall by $500,000. Regional Bank’s reserves rise by $500,000. The pension fund’s deposit at Regional Bank gets credited with $500,000.

Here’s how the balance sheets look afterward:

National Bank:

Regional Bank:

Regional Bank now sits on $500,000 in fresh deposits and $500,000 in new reserves. After setting aside the required reserve — 10%, or $50,000 — Regional Bank has $450,000 in excess reserves ready for lending or further investment. The multiplier process kicks in.

The Equivalence Proof#

Stack the investment transaction next to a standard loan. When National Bank lends $500,000 to a business borrower, the balance sheet looks like this:

National Bank (Lending):

National Bank (Investment, after settlement):

The asset side differs — loans versus securities. But the system-wide effect is identical. In both cases, $500,000 in new deposits enters the banking system. In both cases, those deposits become raw material for further multiplication through the reserve-lending cycle described in the Credit-Creation model.

The equivalence goes deeper. In a lending deal, the bank acquires a claim on a private borrower (the loan). In an investment deal, the bank acquires a claim on a government or corporate issuer (the security). Both are assets on the bank’s books. Both were funded by the creation of new deposits somewhere in the system. The only difference is who owes the money.

This equivalence is not academic trivia. It’s the foundation on which modern central banking operates.

Where the Differences Matter#

Despite the balance sheet equivalence, lending and investment diverge in three important ways.

Risk profile. Government securities — especially those issued by sovereign nations with their own central banks — carry virtually zero default risk. Loans to businesses and individuals carry real credit risk. A bank that creates money by buying Treasuries faces almost no chance of loss on the asset side. A bank that creates money through small business lending might see 2–5% of those loans go bad. This risk gap shapes which channel banks favor under different conditions.

Regulatory treatment. Capital rules assign different risk weights to different asset classes. Under the Basel framework, sovereign debt from top-rated governments gets a 0% risk weight — banks don’t need to hold any capital against it. Commercial loans carry risk weights of 50–150% depending on the borrower. This regulatory tilt makes the investment channel significantly cheaper in capital terms — a fact with outsized consequences during periods of stress.

Counterparty dynamics. Lending needs a willing borrower. Investment needs only a willing seller. During recessions, creditworthy borrowers grow scarce. Businesses shelve expansion plans. Consumers pull back. Banks can’t force people to borrow. But securities markets stay liquid. Banks can always find Treasury bonds to buy. This asymmetry explains why bank investment portfolios tend to swell during downturns while loan books shrink.

The tension between these two channels plays out in real time. In April 2027, CNBC reported that investors in Saba Capital Management’s private credit funds were rushing to redeem their holdings, highlighting how quickly confidence can shift in the investment channel. When fund investors pull out en masse, the forced selling of credit assets can drain deposits from the banking system just as surely as a wave of loan defaults — a reminder that the investment channel carries its own form of systemic fragility.

These differences don’t change the monetary mechanics. Money creation through investment works the same way as money creation through lending. But the differences determine which channel dominates at any given moment — and they explain why central banks have leaned more and more on the investment channel as their go-to policy lever.

Quantitative Easing: The Mechanism at Scale#

The investment channel’s most dramatic real-world application has been quantitative easing (QE) — large-scale securities purchases by central banks.

The mechanics are straightforward, even if the scale is staggering. When the Federal Reserve runs QE, it buys Treasury bonds and mortgage-backed securities from banks and other financial institutions. The Fed pays by crediting the selling bank’s reserve account. New reserves appear. The selling institution gets either reserves (if it’s a bank) or deposits (if it’s a non-bank selling through its bank). Either way, new money enters the system.

Between 2008 and 2014, the Federal Reserve bought roughly $3.7 trillion in securities across three rounds of QE. The monetary base — reserves plus currency — ballooned from about $800 billion to over $4 trillion. Between 2020 and 2022, the Fed bought another $4.6 trillion in response to the COVID-19 pandemic, pushing the base above $8 trillion.

Every single purchase followed the same balance sheet logic. The Fed acquired securities. Banks received reserves. Deposits were created. The investment channel of money creation ran at a scale no one had previously thought possible.

The Bank of Japan pioneered QE back in 2001 and has kept various asset purchase programs running for over two decades. The European Central Bank launched its Asset Purchase Programme in 2015, eventually piling up over EUR 5 trillion in securities. The Bank of England bought over GBP 895 billion. In every case, the plumbing was identical: central bank buys securities, reserves grow, deposits materialize.

Why QE Did Not Cause Hyperinflation#

An obvious question hangs in the air. If QE pumped trillions in new reserves into the system, why didn’t inflation spiral out of control through most of the 2010s?

The answer exposes a critical distinction between reserve creation and deposit multiplication. QE creates reserves — the raw fuel for deposit expansion. But reserves only multiply into broader money when banks actually lend or invest them into the real economy. In the years during and after the 2008 financial crisis, banks chose to sit on their reserves instead.

Excess reserves in the U.S. banking system surged from essentially zero before 2008 to over $2.7 trillion by 2014. Banks were swimming in reserves but had little appetite for lending. Loan demand was weak. Borrower creditworthiness was battered. Regulatory scrutiny was fierce. The multiplier, which in theory could have converted those reserves into tens of trillions in deposits, operated at a fraction of its potential.

This outcome drives home a key point: the money multiplier is not a mechanical gear. It depends on bank behavior, borrower demand, and economic conditions. The investment channel can flood the system with reserves. But the system has to be willing and able to multiply them. When it isn’t, reserves pile up as inert balances on bank balance sheets — potent but dormant.

The Credit-Creation Model: Both Paths Complete#

The Credit-Creation model now covers both channels of deposit creation:

Path 1 — Lending: Bank makes loan → deposit created → borrower spends → deposit lands at another bank → reserve-lending cycle continues → multiplier operates.

Path 2 — Investment: Bank buys security → seller gets deposit → deposit enters banking system → reserve-lending cycle continues → multiplier operates.

Both paths feed the same multiplier process. Both produce the same geometric expansion of deposits across the system. The total money supply reflects the combined output of both channels, shaped by the reserve requirement ratio and the system’s willingness to deploy excess reserves.

This completeness matters for understanding monetary policy. Central banks don’t typically make loans to businesses and consumers. They work primarily through the investment channel — buying and selling securities in open market operations. When the Fed wants to expand the money supply, it buys securities, pumping in reserves. When it wants to shrink the money supply, it sells securities, pulling reserves out.

The lending channel runs on the decisions of thousands of individual banks responding to economic conditions, borrower demand, and risk calculations. The investment channel can be activated directly by the central bank. That gives policymakers a lever — a direct mechanism for moving the money supply without waiting for organic lending to respond.

The Shadow of Contraction#

The investment channel’s power to create also implies a power to destroy. Every security a bank or central bank buys can, in principle, be sold. Every purchase that created deposits can be reversed by a sale that wipes them out.

This symmetry is not just theoretical. Central banks have started pulling the lever in reverse. After years of accumulating securities through QE, the Federal Reserve, the European Central Bank, and the Bank of England have all launched programs to shrink their holdings — a process known as quantitative tightening (QT). The implications reach far beyond textbook models.

When the central bank sells securities, reserves drain from the banking system. The raw material for deposit creation shrinks. The multiplier has less fuel. The same mechanism that expanded the money supply now contracts it — same math, opposite direction.

The investment channel, fully understood, reveals not just how money is born through securities purchases, but how it can die through securities sales. That process of contraction — its mechanics, its chain reactions, its policy stakes — demands its own careful look.