There must first be a suitable borrower
A bank needs a loan application it expects to be profitable relative to the risk. It examines income, collateral, a business plan, existing debts and the likelihood of repayment. Even a highly liquid bank cannot create a sound loan when there is no creditworthy customer or sensible use for the funds.
Demand changes with expectations and interest rates. A household may postpone a mortgage, a business an investment, and a bank may tighten its standards in a recession precisely when applicants fear the future. Lending therefore results from choices on both sides, not a mechanical central-bank command.
Capital absorbs losses
A bank's equity is not a pot from which every loan is directly paid. It is the difference between assets and liabilities and a protective layer against losses. A larger or riskier portfolio usually requires more capital under both regulation and internal risk management.
If a borrower defaults and collateral is insufficient, the loss reduces equity. A bank with too small a capital buffer cannot safely expand and may breach regulatory requirements. Shareholders must therefore bear risk rather than collect only the return on new lending.
Liquidity, funding and interbank payments
A deposit created by a loan may quickly move to another bank. The original bank then needs reserves for settlement or a source from which to obtain them. Customer deposits, market borrowing and liquid assets have different stability and cost. If the market loses confidence, funding can become much more expensive or disappear.
Liquidity rules require banks to hold enough high-quality liquid assets for stressed outflows. A central bank can supply reserves to the system, normally against eligible collateral and at a stated price, but that does not automatically repair bad loans or missing equity.
- credit risk: a borrower may not repay
- liquidity risk: payments leave before assets turn into cash
- funding risk: replacement resources may be costly or unavailable
- capital rules: owners must provide a suitable loss-absorbing layer
Interest rates and feedback from the economy
The central-bank policy rate affects the price of reserves, market rates and the terms on which banks offer loans and deposits. Higher rates usually dampen some demand for debt, but transmission is neither immediate nor identical for every product. Banks add costs, a risk premium, maturity and competitive conditions.
Credit can support investment and trade, but excessive debt growth can inflate asset prices and future losses. Rules therefore balance financing the economy with resilience. The claim that “banks make infinite money from nothing” omits obligations, costs and the possibility of failure.