1. The Usual Picture: Banks Lend Out Savers' Money
The common idea is simple: people save money in a bank, and the bank lends that money to others. In that picture, savings come first and loans come second.
The Bank of England published a paper in 2014 that explains why this is a misconception. It says banks do not act simply as intermediaries that lend out deposits savers have placed with them. It also says they do not "multiply up" central bank money to make new loans [1]. The paper is about the UK, so details can differ in other countries.
So the bakery's loan is not simply a transfer from other customers' accounts. Something else happens, and it is worth following step by step.
2. What Happens When the Bank Says Yes to a Loan
According to the Bank of England, whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower's bank account. That is new money [1]. In the bakery's case, a number appears in the bakery's account, and the bank also records that the bakery owes the same amount.
Most of the money we use today is not paper notes or coins. It is deposits, numbers in bank accounts [1]. That is why a loan can create spendable money. When the bakery pays the oven maker, the deposit moves to the oven maker's bank.
The Bank of England also says the central bank does not decide the exact amount of money in the economy. In normal times, it influences the amount mainly by setting interest rates [1].
3. Why Banks Cannot Lend as Much as They Like
If a loan creates a deposit, you might ask why banks do not simply lend without end. The Bank of England says they cannot create money freely without limit. Banks are limited in how much they can lend if they are to remain profitable in a competitive banking system. Rules set by regulators, called prudential regulation, also constrain them [1].
One reason is that a loan is only worth something if the borrower is expected to pay it back. A bank that lends to businesses that cannot repay will lose money. Bank rules also require banks to hold their own money as a cushion, which the next section explains.
4. The Bank's Own Cushion Against Losses
Some loans will not be repaid. A bakery might close, for example. The bank needs a way to absorb that loss and keep operating.
The US Federal Reserve explains that the main job of a bank's capital is to support its operations and to act as a cushion that absorbs unanticipated losses and drops in the value of its assets. Without that cushion, such losses could cause a bank to fail. Capital also protects people who are owed money by the bank but are not covered by deposit insurance [2].
Capital is the bank's own money, as opposed to money it owes to depositors. A simple way to picture it is a layer at the bottom of a boat that soaks up bumps before water reaches the passengers. That picture is ours, not the Federal Reserve's.
5. What Protects Savers If a Bank Fails Anyway
Even with a cushion, a bank can fail. Many countries have deposit insurance for that case. It is separate from the bank's own capital. They do different jobs: the capital helps the bank absorb losses, while deposit insurance protects savers.
In the US, the FDIC insures deposits up to at least $250,000 per depositor, per ownership category, at each FDIC-insured bank. The FDIC says that since it was founded in 1933, no depositor has lost a penny of insured funds [3]. It covers deposit accounts such as checking and savings accounts, but not products such as stocks, bonds, or mutual funds [4].
In the UK, the Financial Services Compensation Scheme (FSCS) pays compensation of up to £120,000 per eligible person, per bank, building society or credit union, if one fails. The limit rose to that level on 1 December 2025 [5].
6. Putting It Together: Where the Bakery's Money Came From
The bakery's oven money came into existence when the bank approved the loan and created a deposit for the bakery. It did not have to be taken out of someone else's savings first [1]. What keeps this from running out of control is a set of limits and protections: banks must stay profitable and follow regulation [1], they must hold capital to absorb losses [2], and savers' deposits are insured up to a limit in the US and the UK [3][5].
This article leaves out many details, such as how a bank decides whether a business can repay, how much capital each bank must hold, and how interest rates are set. Those are good questions for another day.
7. Try It Yourself: Look Up the Rules Where You Live
Ask an adult to help you find your country's deposit insurance scheme. In the US, the FDIC website has a tool to check whether a bank is insured. In the UK, the FSCS website has a bank and savings protection checker. Then compare that limit with the US and UK limits in this article.
If you enjoy reading original documents, the Bank of England's 2014 paper has a short overview at the start that you can read without the technical parts.