Credit Creation

NotesObjective Test

Credit Creation

In the process of trying to maximise profits, while maintaining sufficient liquidity, banks will aim to lend a proportion of any money which is deposited with them.

They can do this because they know that not all of the money that has been deposited will be withdrawn at the same time.

This is commonly referred to as fractional reserve banking because it involves the bank keeping only a fraction of customers' deposits as cash reserves, and lending out the remainder.

When this loan is spent, it will flow into another bank account as a deposit and will again be lent out by the bank.

In this way, banks 'create' extra deposits of a much greater magnitude than the amount of money originally deposited.

This process is called 'credit creation'.

Illustration of credit creation

We shall assume for simplicity that there is only one bank in the banking system.

  1. Step 1

    Let us assume a customer deposits $1,000 in cash in the bank.

    This $1,000 is an asset for the customer but, for the bank, it is a liability.

    Bank's liabilities (deposits)
    $1,000 deposit

    Bank's assets
    $1,000 cash

  2. Step 2

    Let us assume that the bank has decided (on the basis of past experience and observation) to keep 20 cents in cash for every $1 deposited, and then lend out the other 80 cents.

    In other words, the bank in this example is operating a 20% cash reserve ratio.

    On the basis of the 20% cash ratio, the bank manager decides to keep $200 cash, and make a loan of $800 to Company A.

    Bank's liabilities (deposits)
    $1,000 deposit

    Bank's assets (cash and loans)
    $200 cash and $800 loans

  3. Step 3

    Company A spends the money on goods that it purchases from Company B.

    Company B pays the $800 into their bank account.

    So the bank is now holding $1,000 in cash, but has total deposits of $1,800.

    Bank's liabilities (deposits)
    $1,000 deposit
    $800 extra deposit

    Bank's assets (cash and loans)
    $200 cash and $800 loans
    $800 extra cash

    On the basis of the 20% cash ratio, the bank only needs to be holding $360 (20% x total deposits of $1,800) as cash.

    However, the bank is currently holding $1,000 of cash.

    So there is surplus cash of $1,000 - $360 = $640 available for further lending.

  4. Step 4

    Accordingly the bank lends $640 to another customer seeking a loan.

    Bank's liabilities (deposits)
    $1,000 deposit
    $800 deposit

    Bank's assets (= cash and loans)
    $200 cash and $800 loan
    $160 cash
    $640 loan

    The bank can continue with this process of depositing and lending as long as the cash reserve ratio is maintained.

    However, even by the end of step (4) in our simple example, we can see that, through the process of credit creation, the bank now has deposits of $1,800 compared to the initial deposit of $1,000. So, it has 'created' extra deposits of $800.

NotesObjective Test