MATTHEW JOHNSTON Dec 19, 2020 https://www.investopedia.com/articles/investing/022416/why-banks-dont-need-your-money-make-loans.asp How It Works, Banks in the Real World, What Really Affects Banks’ Ability to Lend, The Bottom Line
- As Joseph Schumpeter once wrote, “It is much more realistic to say that the banks ‘create credit,’ that is, that they create deposits in their act of lending than to say that they lend the deposits that have been entrusted to them.”2
- The loan counts as an asset to the bank and it is simultaneously offset by a newly created deposit, which is a liability of the bank to the depositor holder. Contrary to the story described above, loans actually create deposits.
- if loans create deposits, private banks are creators of money. But you might be asking, “Isn’t the creation of money the central banks’ sole right and responsibility?”
Traditional introductory economic textbooks generally treat banks as financial intermediaries, the role of which is to connect borrowers with savers, facilitating their interactions by acting as credible middlemen. Individuals who earn an income above their immediate consumption needs can deposit their unused income in a reputable bank, thus creating a reservoir of funds. The bank can then draw on those from those funds in order to loan out to those whose incomes fall below their immediate consumption needs. Read on to see how banks really use your deposits to make loans and to what extent they need your money to do so. Key takeaways:
- Banks are thought of as financial intermediaries that connect savers and borrowers.
- However, banks actually rely on a fractional reserve banking system whereby banks can lend more than the number of actual deposits on hand.
- This leads to a money multiplier effect. If, for example, the amount of reserves held by a bank is 10%, then loans can multiply money by up to 10x. The reserve requirement does not act as a binding constraint on banks’ ability to lend and consequently their ability to create money. The reality is that banks first extend loans and then look for the required reserves later.
- Banks are limited by profitability considerations; that is, given a certain demand for loans, banks base their lending decisions on their perception of the risk-return trade-offs, not reserve requirements. Expectations of profitability, then, remain one of the leading constraints on banks’ ability, or better, willingness, to lend. And it is for this reason that although banks don’t need your money, they do want your money. As noted above, banks lend first and look for reserves later, but they do look for the reserves. Banks don’t need your money, but yours is cheaper (0.01% to 0.02% interest rate the Bank of America pays on a standard checking deposit).56 than 0.25% from the Federal Reserve or up to .75% from other banks.
How It Works
According to what we are taught (about people’s deposits creating loans), the lending capacity of a bank is limited by the magnitude of their customers’ deposits. In order to lend out more, a bank must secure new deposits by attracting more customers. Without deposits, there would be no loans, or in other words, deposits create loans. Of course, this story of bank lending is usually supplemented by the money multiplier theory that is consistent with what is known as fractional reserve banking.
In a fractional reserve system, only a fraction of a bank’s deposits needs to be held in cash or in a commercial bank’s deposit account at the central bank. The magnitude of this fraction is specified by the reserve requirement, the reciprocal of which indicates the multiple of reserves that banks are able to lend out. If the reserve requirement is 10% (i.e., 0.1) then the multiplier is 10, meaning banks are able to lend out 10 times more than their reserves.
The capacity of bank lending is not entirely restricted by banks’ ability to attract new deposits, but by the central bank’s monetary policy decisions about whether or not to increase reserves. However, given a particular monetary policy regime and barring any increase in reserves, the only way commercial banks can increase their lending capacity is to secure new deposits. Again, deposits create loans, and consequently, banks need your money in order to make new loans.
In March 2020, the Board of Governors of the Federal Reserve System reduced reserve requirement ratios to 0%, effectively eliminating them for all depository institutions.1
Banks in the Real World
In today’s modern economy most money takes the form of deposits, but rather than being created by a group of savers entrusting the bank withholding their money, deposits are actually created when banks extend credit (i.e., create new loans). As Joseph Schumpeter once wrote, “It is much more realistic to say that the banks ‘create credit,’ that is, that they create deposits in their act of lending than to say that they lend the deposits that have been entrusted to them.”2
When a bank makes a loan, there are two corresponding entries that are made on its balance sheet, one on the assets side and one on the liabilities side. The loan counts as an asset to the bank and it is simultaneously offset by a newly created deposit, which is a liability of the bank to the depositor holder. Contrary to the story described above, loans actually create deposits.
Now, this may seem a bit shocking since, if loans create deposits, private banks are creators of money. But you might be asking, “Isn’t the creation of money the central banks’ sole right and responsibility?” Well, if you believe that the reserve requirement is a binding constraint on banks’ ability to lend then yes, in a certain way banks cannot create money without the central bank either relaxing the reserve requirement or increasing the number of reserves in the banking system.
The truth, however, is that the reserve requirement does not act as a binding constraint on banks’ ability to lend and consequently their ability to create money. The reality is that banks first extend loans and then look for the required reserves later.
Fractional reserve banking is effective, but can also fail. During a “bank run,” depositors all at once demand their money, which exceeds the amount of reserves on hand, leading to a potential bank failure.
What Really Affects Banks’ Ability to Lend
So if bank lending is not restricted by the reserve requirement then do banks face any constraint at all? There two sorts of answers to this question, but they are related. The first answer is that banks are limited by profitability considerations; that is, given a certain demand for loans, banks base their lending decisions on their perception of the risk-return trade-offs, not reserve requirements.
The mention of risk brings us to the second, albeit related, answer to our question. In a context whereby deposit accounts are insured by the federal government, banks may find it tempting to take undue risks in their lending operations. Since the government insures deposit accounts, it is in the government’s best interest to put a damper on excessive risk-taking by banks. For this reason, regulatory capital requirements have been implemented to ensure that banks maintain a certain ratio of capital to existing assets.3
If bank lending is constrained by anything at all, it is capital requirements, not reserve requirements. However, since capital requirements are specified as a ratio whose denominator consists of risk-weighted assets (RWAs), they are dependent on how risk is measured, which in turn is dependent on the subjective human judgment.4
Subjective judgment combined with ever-increasing profit-hungriness may lead some banks to underestimate the riskiness of their assets. Thus, even with regulatory capital requirements, there remains a significant amount of flexibility in the constraint imposed on banks’ ability to lend.
The Bottom Line
Expectations of profitability, then, remain one of the leading constraints on banks’ ability, or better, willingness, to lend. And it is for this reason that although banks don’t need your money, they do want your money. As noted above, banks lend first and look for reserves later, but they do look for the reserves.
Attracting new customers is one way, if not the cheapest way, to secure those reserves. Indeed, the current targeted fed funds rate—the rate at which banks borrow from each other—is between 0.25% and 0.75%, well above the 0.01% to 0.02% interest rate the Bank of America pays on a standard checking deposit.56 The banks don’t need your money; it’s just cheaper for them to borrow from you than it is to borrow from other banks.
Board of Governors of the Federal Reserve System. “Reserve Requirements.” Accessed Oct. 2, 2020.
Joseph A. Schumpeter. “History of Economic Analysis,” Page 1114. Routledge, 2006.
Federal Deposit Insurance Corporation. “Regulatory Capital.” Accessed Oct. 2, 2020.
BIS. “Calculation of RWA for credit risk.” Accessed Oct. 2, 2020.
Bank of America. “Deposit Interest Rates & Annual Percentage Yields (APYs),” Page 1. Accessed Oct. 2, 2020.
Federal Reserve. “Current Interest Rates.” Accessed Oct. 2, 2020.
Forbes, 2017 https://www.forbes.com/sites/francescoppola/2017/10/31/how-bank-lending-really-creates-money-and-why-the-magic-money-tree-is-not-cost-free/?sh=1724e30d3073
- The vast majority of money (97%) comes into being when a commercial bank extends a loan. The rules of double entry accounting dictate that when banks create a new loan asset, they must also create an equal and opposite liability, in the form of a new demand deposit. This demand deposit, like all other customer deposits, is included in central banks’ measures of broad money. In this sense, therefore, when banks lend they create money.
- The new money is fully backed by a new asset – a loan.
- 27% of bank lending goes to other financial corporations; 50% to mortgages (mainly on existing residential property); 8% to high-cost credit (including overdrafts and credit cards); and just 15% to non-financial corporates, that is, the productive economy.
- Banks do not work to a money-multiplier model, where they extend loans as a multiple of the deposits they already hold.
- Commercial banks’ ability to create money is constrained by capital. Central banks’ ability to create money is constrained by the willingness of their government to back them.
- Bank money creation comes from lending, and bank lending does not in any way crowd out government investment in social programs. Government can fund anything it wants to, if necessary by forcing the central bank to pay for it. If government doesn’t invest in the people of today and tomorrow, it is not because of shortage of money, it is because of the ideological beliefs of those who make the spending decisions and, in Western democracies, those who elect them.
Oct 31, 2017
How Bank Lending Really Creates Money, And Why The Magic Money Tree Is Not Cost Free
According to a poll conducted by City AM on behalf of the “sovereign money” advocates Positive Money, 84% of British lawmakers don’t know that banks create money when they lend. This is despite the fact that in 2014, the Bank of England produced a definitive statement to that effect.
Shocked by politicians’ ignorance, The Guardian’s Zoe Williams took it upon herself to explain how bank lending works:
How is money created? Some is created by the state, but usually in a financial emergency. For instance, the crash gave rise to quantitative easing – money pumped directly into the economy by the government. The vast majority of money (97%) comes into being when a commercial bank extends a loan. Meanwhile, 27% of bank lending goes to other financial corporations; 50% to mortgages (mainly on existing residential property); 8% to high-cost credit (including overdrafts and credit cards); and just 15% to non-financial corporates, that is, the productive economy.
The link in this paragraph is to the Bank of England’s aforementioned definitive statement. Sadly, Zoe did not understand it. If she had, she would not have gone on to say this:
Is there a magic money tree? All money comes from a magic tree, in the sense that money is spirited from thin air. There is no gold standard. Banks do not work to a money-multiplier model, where they extend loans as a multiple of the deposits they already hold. Money is created on faith alone, whether that is faith in ever-increasing housing prices or any other given investment. This does not mean that creation is risk-free: any government could create too much and spawn hyper-inflation. Any commercial bank could create too much and generate over-indebtedness in the private economy, which is what has happened. But it does mean that money has no innate value, it is simply a marker of trust between a lender and a borrower. So it is the ultimate democratic resource. The argument marshalled against social investment such as education, welfare and public services, that it is unaffordable because there is no magic money tree, is nonsensical. It all comes from the tree; the real question is, who is in charge of the tree?
This is one of the most muddled paragraphs I have ever read.
Firstly, it is entirely incorrect to say that money is “spirited from thin air.” It is not. Indeed, Zoe herself said it is not, in the previous paragraph. Money is created when banks lend. The rules of double entry accounting dictate that when banks create a new loan asset, they must also create an equal and opposite liability, in the form of a new demand deposit. This demand deposit, like all other customer deposits, is included in central banks’ measures of broad money. In this sense, therefore, when banks lend they create money. But this money has in no sense been “spirited from thin air”. It is fully backed by a new asset – a loan. Zoe completely ignores the loan asset backing the new money.
Nor does the creation of money by commercial banks through lending require any faith other than in the borrower’s ability to repay the loan with interest when it is due. Mortgage lending does not require ever-rising house prices: stable house prices alone are sufficient to protect the bank from loan defaults.
Commercial banks’ ability to create money is constrained by capital. When a bank creates a new loan, with an associated new deposit, the bank’s balance sheet size increases, and the proportion of the balance sheet that is made up of equity (shareholders’ funds, as opposed to customer deposits, which are debt, not equity) decreases. If the bank lends so much that its equity slice approaches zero – as happened in some banks prior to the financial crisis – even a very small fall in asset prices is enough to render it insolvent. Regulatory capital requirements are intended to ensure that banks never reach such a fragile position. We can argue about whether those requirements are fit for purpose, but to imply – as Williams does – that banks can lend without restraint is simply wrong. There is no “magic money tree” in commercial banking.
It is of course possible for banks to lend more than the population can realistically afford. But we should remember that prior to the financial crisis, political authorities actively encouraged and supported excessive bank lending, particularly real estate lending, in the mistaken belief that vibrant economic growth would continue indefinitely, enabling the population to cope with its enormous debts. “We will never return to the old boom and bust,” said the U.K.’s finance minister Gordon Brown in 2007. Such is the folly of politicians.
In contrast, central banks’ ability to create money is constrained by the willingness of their government to back them, and the ability of that government to tax the population. In practice, most central bank money these days is asset-backed, since central banks create new money when they buy assets in open market operations or QE, and when they lend to banks. However, in theory a central bank could literally “spirit money from thin air” without asset purchases or lending to banks. This is Milton Friedman’s famous “helicopter drop.” The central bank would become technically insolvent as a result, but provided the government is able to tax the population, that wouldn’t matter. Some central banks run for years on end in a state of technical insolvency (the central bank of Chile springs to mind).
The ability of the government to tax the population depends on the credibility of the government and the productive capacity of the economy. Hyperinflation can occur when the supply side of the economy collapses, rendering the population unable and/or unwilling to pay taxes. It can also occur when people distrust a government and its central bank so much that they refuse to use the currency that the central bank creates. Distrust can come about because people think the government is corrupt and/or irresponsible, as in Zimbabwe, or because they think that the government is going to fall and the money it creates will become worthless (this is why hyperinflation is common in countries that have lost a war). But nowhere in the genesis of hyperinflation does central bank insolvency feature.
So the equivalence that Williams draws between hyperinflation and commercial bank lending is completely wrong. A central bank can create money without limit, though doing so risks inflation. Commercial banks simply can’t do this.However, on one thing Williams is entirely correct. Now there is no gold standard, money is indeed a matter of faith. But faith in what, and whom?
Certainly not commercial banks. People trust the money created by commercial banks firstly because it is exchangeable one-for-one with central bank created money, and secondly because governments guarantee its value up to a limit ($250,000 in the U.S.; 100,000 euros in the Eurozone; £75,000 in the U.K.). Deposit insurance effectively turns the money created by commercial banks into government money.
But even the money created by central banks requires a government guarantee. The dollar is backed by the “full faith and credit of the U.S. government.” And central banks are mandated by governments to maintain the value of the money they create. That’s what their inflation target means.
So, faith in money is, in reality, faith in the government that guarantees it. That in turn requires faith in the future productive capacity of the economy. As the productive capacity of any economy ultimately comes from the work of people, we could therefore say that faith in money is faith in people, both those now on the earth and those who will inhabit it in future. The “magic money tree” is made of people, not banks.
Williams complains that money creation by banks prevents social investment by government. But bank money creation comes from lending, and bank lending does not in any way crowd out government investment in social programs. Government can fund anything it wants to, if necessary by forcing the central bank to pay for it. If government doesn’t invest in the people of today and tomorrow, it is not because of shortage of money, it is because of the ideological beliefs of those who make the spending decisions and, in Western democracies, those who elect them.
However, the fruit of the “magic money tree” is not cost-free. If the central bank creates more money than the present and future productive capacity of the economy can absorb, the result is inflation. If it doesn’t create enough, the result is deflation: the reason why gold standards tend to be deflationary is that the money supply does not increase in line with the productive capacity of the economy. The problem for governments and central bankers is deciding what the present and future productive capacity of the economy is, and therefore how much money the economy needs now and will need in the future. This is more of a black art than a science.
Williams calls for a “public authority” to create money. But, given how difficult it is to estimate the present and future productive capacity of the economy, I find it hard to see how a public authority can be a better creator of purchasing power than banks. Flawed though it is, money creation through bank lending at least responds to demand.
However, that demand may not come from the most productive sectors. U.K. banks lend mainly for real estate purchase, and are frequently criticised for failing to lend to small and medium-size enterprises. To remedy this, Williams calls for commercial banks to be stripped of their power to create money. How this would ensure that bank lending in future was more productively directed is hard to imagine, unless she is also thinking of nationalizing the banks so that the state can direct their lending. But this is more than slightly illogical. In the U.K., successive governments have for the last half-century openly promoted and supported residential mortgage lending to create a “property-owning democracy.” The current government has just proposed increasing government support for the residential property market. Why on earth would a U.K. government suddenly change course and direct newly nationalized banks to lend to businesses instead of households?
But we don’t need to change the way money is created in order to have the things Williams mentions. We can have helicopter money instead of QE. We can have investment in green infrastructure and education. We can have universal basic income or a citizen’s dividend. These are public policy decisions. They are not cost-free, of course – but they have nothing whatsoever to do with banks.
Stop blaming banks for the abject failure of governments to provide the fiscal stimulus that our damaged economies so badly need. Put the blame where it belongs – with politicians, and those who elected them.Frances Coppola
I used to work for banks. Now I write about them, and about finance and economics generally. Although I originally trained as a musician and singer, I worked in banking… Read More
How Banks Create Money – Positive Money
https://positivemoney.org › how-banks- create-money
the Bank of England itself has confirmed that “whenever a bank makes a loan, it creates a deposit in the borrower’s bank account, thereby creating new money.”
Unfortunately, banks direct most of their lending towards property and financial speculation, which pushes up house prices and makes financial crises more likely. Banks prefer lending to the ‘financial’ economy than the ‘real’ economy, where most ordinary people would see the benefit. This means they do a bad job of lending to businesses which create jobs and grow the economy in a sustainable way.
And because commercial banks were slow to start lending again after the 2008 crisis, the Bank of England stepped in with its own money creation programme called quantitative easing. It’s chosen to pump this new money into the financial sector, which is pushing up the value of assets like houses, shares, and corporate bonds.
This policy has done very little for ordinary people, but the Bank of England’s own research has shown that quantitative easing made the richest 5% over £128,000 richer. So at a time when politicians are using the absence of a “magic money tree” to justify austerity, the Bank of England policies are enriching a wealthy few.
All of this exposes how dysfunctional our money and banking system is. But we know it doesn’t have to be this way. We can reform the system so that it supports a fairer and more sustainable economy.
- Instead of the Bank of England pumping new money into financial markets through quantitative easing, it should be spent via the government into infrastructure, green technology, or as a cash transfer to help households pay off their debts and improve their finances.
- And we need to transform our banking system so that banks lend money to support investment and jobs in the real economy. This means having a more diverse range of banks and government policies that encourage lending for productive purposes.
Economist J.K. Galbraith once suggested that the reason people are hesitant to accept the credit theory of money creation is that:
“the process by which banks create money is so simple that the mind is repelled when something so important is involved, a deeper mystery seems only decent.”
Whenever money is created, an accompanying amount of debt is created as well.
That means financial policy should be set up to step in a fix things when the debt burden becomes too high.
- From an economic viewpoint, commercial banks create private money by transforming an illiquid asset (the borrower’s future ability to repay) into a liquid one (bank deposits)
In addition to bank solvency representing a constraint on private money creation, banks require access to liquid reserves in order to be able to engage in money creation. 312
In contemporary societies, the great majority of money is created by commercial banks rather than the central bank. Whenever a bank makes a loan, it simultaneously creates a matching deposit on the liability side of its balance sheet.1 This happens when, say, a new mortgage contract is concluded, but also seamlessly in everyday life. If, for instance, you pay for your morning commute coffee using your Barclays (or Deutsche Bank or Bank of America) credit card, you have just been handed a Barclays-IOU (or a Deutsche Bank-IOU or a Bank of America-IOU, but you get the flavour). We could also call this IOU a Barclays-pound. Conveniently, that Barclays-pound is denominated in GBP and is treated by your coffee vendor as trading with a one-to-one pegged exchange rate to British pound sterling. Practically speaking, you can make transactions using the Barclays-pound just as well as you could using a cash note printed on behalf of the Bank of England. Although this understanding of the money creation process is hardly new (e.g. Tobin 1963), over the past couple of years, it has been thrown into the public spotlight by the publication of several comprehensive guides on the operational realities of money creation in the modern economy by central banks such as the Bank of England (2014) and Deutsche Bundesbank (2017), as well as by campaigning by such groups as Positive Money.
Unfortunately, the fact that the money we use is mostly issued by private banks and that its creation operationally involves not much more than a few keystrokes has led to a widely circulating but erroneous belief that banks create money out of nothing. To mention but three examples, Richard Werner (2014) writes in a peer-reviewed article: “The money supply is created as ‘fairy dust’ produced by the banks individually, ‘out of thin air’”. Zoe Williams (2017) in The Guardian suggests that “[all] money comes from a magic tree, in the sense that money is spirited from thin air”. And David Graeber (2019) opines in the New York Review of Books: “There are plenty of magic money trees in Britain, as there are in any developed economy. They are called ‘banks’. Since modern money is simply credit, banks can and do create money literally out of nothing, simply by making loans”. This misconception may stem from the seemingly magical simultaneous appearance of entries on both the liability and the asset side of a bank’s balance sheet when it creates a new loan. But this is simply a reflection of double-entry bookkeeping. Economically, money creation by private banks is far from magic, nor is it out of thin air.
There are several ways in which banks’ ability to create money through lending is constrained, meaning that the idea of limitless money creation conjured up by the image of a ‘magic money tree’ is flawed. The aforementioned central bank explainers cover the operational details with much greater expertise than we could claim for ourselves.2 Instead, we want to draw attention to a fundamental economic point that is underlying these constraints. When banks create money, they do so not out of thin air, they create money out of assets – and assets are far from nothing.
A simple parable helps clarify how banks create money and what the role of asset-backing is in that process. Suppose a PhD student new to the British town of Cambridge – let’s call him Lukas – would like to celebrate a day’s worth of work with a pint at a local pub and pay for the drink by issuing an IOU. Unfortunately, the pub refuses to accept the Lukas-IOU. After all, the pub doesn’t know Lukas very well, and it can therefore not trust that he will have the ability to repay the IOU at a later point in time. Moreover, a third party, say a brewery, would not accept the Lukas-IOU as payment for their restocking of the pub’s beer inventory either – the Lukas-IOU is both risky as an asset to hold, and worthless for third-party transactions. Fortunately for Lukas, his supervisor – let’s call him Pontus – happens to have a lot of trust in Lukas, and is willing to accept the Lukas-IOU in exchange for a Pontus-IOU in return. Here is the crux – the local pub does indeed trust Pontus, and so do third parties (“oh, it’s a Pontus-IOU – that’s as good as the pound note in my wallet!”). Lukas can then get his well-deserved drink by paying with the Pontus-IOU. And the brewery can restock their inventory by paying with the same means.
Seemingly like magic, Pontus has just created money out of thin air! But only seemingly. Why would the local pub trust Pontus and treat his IOU as good as money? There are a few reasons. First, they trust his ability to screen Lukas’ repayment capacity, so he has a healthy ‘asset’ backing up his own IOU. Second, he also happens to have liquid reserves on his savings account. Thus, if the pub asked to have the IOU cleared well before Lukas is able to settle his accounts with Pontus, he can always honour his promises by using those reserves. Has money appeared magically out of thin air? No. Pontus has created an IOU that is treated like money by third parties out of Lukas’ repayment capacity, which is equal to a stream of repayments in the future. A stream of repayments is the same as a stream of dividends, so the money Pontus created was out of an asset. If, on the other hand, Pontus were to be so reckless to issue IOUs without the backing of solid assets, or if he didn’t have access to liquid reserves with which to immediately settle any transactions, the air would suddenly get very thick, and the pub and other third parties would soon find out, and his IOUs would lose their value altogether.
When banks create money, the process is very similar to that told in the parable. In the above example, when you paid for your coffee using a Barclays credit card, you gave them an asset – your future repayments – and they handed you a Barclays-IOU in return. These Barclays-pounds are accepted in society as a means of payment (i.e. money), as Barclays is trusted to hold healthy assets as well as British pound reserves issued by the Bank of England.3 That privately issued money is asset-backed represents a fundamental precondition for it to be traded at par with central bank issued money, which comes in the form of currency (which individuals and businesses can use to settle transactions) or reserves (which commercial banks use for the same purpose). In addition to bank solvency representing a constraint on private money creation, banks additionally require access to these public monies in order to be able to engage in liquidity transformation – or money creation.
Lastly, suppose that, for some reason, Barclays’ customers suspected that it held unhealthy assets – that is, there was doubt regarding the repayment capacity of Barclays’ debtors – or that it did not have sufficient reserves to settle transactions on their behalf. This would undermine the pegged exchange rate between Barclays-pounds and British pounds on which the banks edifice stands. Eventually, this would lead to a run on the bank, and it would quickly find itself illiquid, or even insolvent. This is indeed what happened to several banks during the Global Crisis, including Countrywide Financial in the US and Northern Rock in the UK. If banks were indeed able to create money out of nothing, why would we need to bail them out?
Bank of England (2014), “Money creation in the modern economy”, Quarterly Bulletin, 2014 Q1.
Bundesbank (2017), “The role of banks, non-banks and the central bank in the money creation process”, Monthly Report 2017.
Graeber, D (2019), “Against economics”, The New York Review of Books, 5 December.
Tobin, J (1963), “Commercial banks as creators of ‘money’”, Cowles Foundation discussion Paper 159.
Werner, R (2014), “Can banks individually create money out of nothing? – The theories and the empirical evidence”, International Review of Financial Analysis 36: 1-19.
Williams, Z (2019), “How the actual magic money tree works”, The Guardian.
 The understanding that private banks create money through lending – a view variously referred to as ‘endogenous money’ or ‘loans first’ – contrasts with the ‘reserves first’ theory according to which central banks choose the quantity of reserves available to private banks. These reserves are then ‘multiplied up’ in a stable ratio of broad money to base money as banks respond to a greater (smaller) supply of reserves by expanding (contracting) lending. But this is beside the point of the column, which aims to clear up the misunderstanding that banks can create money out of nothing.
 A summary may be convenient for some readers. For one thing, the lending activity of any individual bank, and hence money creation, is limited by its holdings of central bank reserves, since when the borrower uses the newly obtained funds to make a payment to a seller with an account at a different bank, the borrower’s bank will frequently have to use reserves to settle this transaction. Second, households and businesses are not only one party in the process of money creation, but through activities such as loan repayment they also contribute to money destruction. Thus, if an individual took out a new loan but did so for the purpose of mortgage refinancing, the net money creation would be (approximately) zero. And third, a whole host of factors affect and limit the incentives for borrowers to take out loans and for banks to create money, including the various parties’ risk perception and appetite, and the stance of monetary policy. For example, the federal funds rate in the US or the Bank Rate in the UK, the primary instruments of the Federal Reserve and the Bank of England, respectively, influence the costs banks face in acquiring reserves as well as the demand for credit coming from households and businesses.
 Alongside access to public money in the form of central bank reserves, the commercial bank may also be able to guarantee liquidity through alternatives such as its own equity or assets of high liquidity, for instance high-quality government bonds (which are treated akin to money by institutional investors such as pension funds).
Credit Creation by Commercial Banks and It’s Limitations
Article Shared by Nitisha
A central bank is the primary source of money supply in an economy through circulation of currency.
It ensures the availability of currency for meeting the transaction needs of an economy and facilitating various economic activities, such as production, distribution, and consumption.
However, for this purpose, the central bank needs to depend upon the reserves of commercial banks. These reserves of commercial banks are the secondary source of money supply in an economy. The most important function of a commercial bank is the creation of credit.
Therefore, money supplied by commercial banks is called credit money. Commercial banks create credit by advancing loans and purchasing securities. They lend money to individuals and businesses out of deposits accepted from the public. However, commercial banks cannot use the entire amount of public deposits for lending purposes. They are required to keep a certain amount as reserve with the central bank for serving the cash requirements of depositors. After keeping the required amount of reserves, commercial banks can lend the remaining portion of public deposits.
According to Benham’s, “a bank may receive interest simply by permitting customers to overdraw their accounts or by purchasing securities and paying for them with its own cheques, thus increasing the total bank deposits.”
Let us learn the process of credit creation by commercial banks with the help of an example.
Suppose you deposit Rs. 10,000 in a bank A, which is the primary deposit of the bank. The cash reserve requirement of the central bank is 10%. In such a case, bank A would keep Rs. 1000 as reserve with the central bank and would use remaining Rs. 9000 for lending purposes.
The bank lends Rs. 9000 to Mr. X by opening an account in his name, known as demand deposit account. However, this is not actually paid out to Mr. X. The bank has issued a check-book to Mr. X to withdraw money. Now, Mr. X writes a check of Rs. 9000 in favor of Mr. Y to settle his earlier debts.
The check is now deposited by Mr. Y in bank B. Suppose the cash reserve requirement of the central bank for bank B is 5%. Thus, Rs. 450 (5% of 9000) will be kept as reserve and the remaining balance, which is Rs. 8550, would be used for lending purposes by bank B.
Thus, this process of deposits and credit creation continues till the reserves with commercial banks reduce to zero.
This process is shown in the Table-1:
From Table-1, it can be seen that deposit of Rs. 10,000 leads to a creation of total deposit of Rs. 50,000 without the involvement of cash.
The process of credit creation can also be learned with the help of following formulae:
Total Credit Creation = Original Deposit * Credit Multiplier Coefficient
Credit multiplier coefficient= 1 / r where r = cash reserve requirement also called as Cash Reserve Ratio (CRR)
Credit multiplier co-efficient = 1/10% = 1/ (10/100) = 10
Total credit created = 10,000 *10 = 100000
If CRR changes to 5%,
Credit multiplier co-efficient = 1/5% = 1/ (5/100) = 20
Total credit creation = 10000 * 20 = 200000
Thus, it can be inferred that lower the CRR, the higher will be the credit creation, whereas higher the CRR, lesser will be the credit creation. With the help of credit creation process, money multiplies in an economy. However, the credit creation process of commercial banks is not free from limitations.
Some of the limitations of credit creation by commercial banks are shown in Figure-3:
The limitations of credit creation process (as shown in Figure-3) are explained as follows:
(a) Amount of Cash:
Affects the creation of credit by commercial banks. Higher the cash of commercial banks in the form of public deposits, more will be the credit creation. However, the amount of cash to be held by commercial banks is controlled by the central bank.
The central bank may expand or contract cash in commercial banks by purchasing or selling government securities. Moreover, the credit creation capacity depends on the rate of increase or decrease in CRR by the central bank.
Refers to reserve ratio of cash that need to be kept with the central bank by commercial banks. The main purpose of keeping this reserve is to fulfill the transactions needs of depositors and to ensure safety and liquidity of commercial banks. In case the ratio falls, the credit creation would be more and vice versa.
Imply the outflow of cash. The credit creation process may suffer from leakages of cash.
The different types of leakages are discussed as follows:
(i) Excess Reserves:
Takes place generally when the economy is moving towards recession. In such a case, banks may decide to maintain reserves instead of utilizing funds for lending. Therefore, in such situations, credit created by commercial banks would be small as a large amount of cash is resented.
(ii) Currency Drains:
Imply that the public does not deposit all the cash with it. The customers may hold the cash with them which affects the credit creation by banks. Thus, the capacity of banks to create credit reduces.
(d) Availability of Borrowers:
Affects the credit creation by banks. The credit is created by lending money in form of loans to the borrowers. There will be no credit creation if there are no borrowers.
(e) Availability of Securities:
Refers to securities against which banks grant loan. Thus, availability of securities is necessary for granting loan otherwise credit creation will not occur. According to Crowther, “the bank does not create money out of thin air; it transmutes other forms of wealth into money.”
(f) Business Conditions:
Imply that credit creation is influenced by cyclical nature of an economy. For example, credit creation would be small when the economy enters into the depression phase. This is because in depression phase, businessmen do not prefer to invest in new projects. In the other hand, in prosperity phase, businessmen approach banks for loans, which lead to credit creation.
In spite of its limitations, we can conclude that credit creation by commercial banks is a significant source for generating income.
The essential conditions for creation of credit are as follows:
a. Accepting the fresh deposits from public
b. Willingness of banks to lend money
c. Willingness of borrowers to borrow.
Prof. Richard Werner’s article (Science Direct) provides an extraordinary look and insights into our monetary and banking system over the past 165 years, and how poorly understood it is by most people today, even by most economists.
That banks ‘create credit’ may well be the most significant factor of our economic system, because as we all know from experience, nothing of any major impact can be achieved without credit, without money.
Public banking lives or dies on the veracity of this point…and it will live because thanks to the landmark empirical studies of Prof Richard Werner, which explains what occurs when banks issue a loan. https://www.sciencedirect.com/science/article/pii/S1057521914001434
We will use the less offensive terms ‘credit creation’ or ‘create credit’ wherever we can. (Thanks David Alley for your insistence on this .. no need to alienate our audience, or give leeway to private bank ridicule).