Credit Creation

Think about the cash in your pocket: it has a physical form that you can easily touch. However, that’s not quite the case for bank deposits. The only way you can view your bank deposit is by accessing your bank account statement or just checking your bank’s app on your phone. But why is this relevant to credit creation and how do banks create credit? Read this article to find out!

Credit creation: definition

Bank deposits play an instrumental role in the process of credit creation. Most of the time these bank deposits are used to make fund transfers from one account to the other. This makes them one of the most common forms of money. As banks can easily create bank deposits, this has pushed cash to be a relatively small part of the total money circulating in an economy.

This is pretty much how bank deposits work and how credit creation takes place. By expanding their deposits, banks create credit in an economy. They do this by loaning a part of the deposits they have, therefore, generating money and funds for other people.

Credit Creation theory

Credit creation theory states that commercial banks can generate money in an economy. Additionally, as a result of their lending activities, banks produce deposits which then create new purchasing power.

The capacity of a bank to produce new money, often known as 'credit money,' is determined by many variables. To begin with, non-cash transactions account for most of the transactions in the economy, and non-cash transactions are resolved via non-cash transfers inside the banking system.

Combining lending and deposit-taking operations allows banks to produce credit money. The capacity of banks to issue credit monthly is partly a result of their exemption from the ‘client money rules’. That's because non-bank organisations such as stockbrokers are required to keep clients' money separate from the non-bank organisation's assets and liabilities on their balance sheet, which is also what prevents them from creating credit money.

Banks' exemption from the client money restrictions, on the other hand, allows them to relabel liabilities on their balance sheet at various phases of the lending process, allowing them to increase their balance sheets.

Banks' capacity to create money is limited by their need to maintain an adequate gap between the interest rate obtained on money lent and the cost of bank capital. Rapid growth in bank lending would require a reduction in the interest rate offered to borrowers, lowering bank profitability.

In addition to that, a bank must ensure that it has enough provisions and capital to absorb unforeseen losses resulting from bad and doubtful loans while still complying with the reserve requirement set by the Central Bank.

How do banks create credit? The credit creation process

Every bank receives deposits from its customers and uses these deposits to make loans to other individuals or businesses. All banks are required to keep a portion of these deposits in their reserves.

The reason why they keep only a portion is that not all clients are expected to withdraw their funds at once. This allows banks to keep a portion and loan the rest of the money. If everyone wanted to withdraw money at once, banks would have to keep everything in their deposits rather than just a portion.

A ‘monopoly’ banking system

Let's assume that there's a monopoly banking system, where there is just one commercial bank operating in an economy.

Let’s assume that the bank is required to keep 20% of the deposits on its reserves in case the customers want to withdraw their funds. Normally, there’s a balance between the number of people withdrawing from the bank and the number of people depositing in the bank. As such, the bank doesn’t have to keep all of the deposits in its cash reserves.

Let’s start with someone depositing £1000 in a commercial bank.

If person A goes to the bank and deposits £1000, the bank will then keep £200 on their cash reserves. What happens to the remaining £800? The bank uses them to generate loans. How? The bank lends these £800 to person B who has a credit account where the funds are stored.

Now, person B has £800 in their account. The bank keeps £160 in their reserves and lends the remaining £640 to person C. Person C also has a credit account where these funds are stored. The bank again keeps 20%, namely £128, and lends the remaining to person D.

The bank continues this process until the entire primary deposit is distributed and loaned out.

The total deposits that the bank created are 800+640+512+….=5000. This way the bank has managed to create £5000 which serves as money from an initial deposit of £1000.

Table 1. Credit creation example.

Table 1 summarizes all the transactions mentioned in the example above. Instead of adding the deposits and going through the entire process, you can calculate how much money is created by a deposit using the money multiplier. The money multiplier formula is equal to one divided by the required reserve ratio.

In the example above, we have a required reserve ratio of 20%. The money multiplier is then 5, which means that £1 can theoretically generate £5. In our case £1000 x 5 = £5000.

A ‘multi-bank’ banking system

The real world is different from a ‘monopoly banking’ system. The main difference is that there are many commercial banks in the economy where a person can deposit their funds or take a loan from. Some of the biggest commercial banks in the UK are HSBC, Barclays, and Lloyds.

The fact that there are many banks is what makes it a 'multi-bank’ system. The process through which a single bank created £5000 in deposits also holds for a system with multiple banks. The deposits are spread all over the banks, assuming that all the banks lend the 80% remaining from a cash deposit.

However, this is conditional on the success of customers being able to pay back their loans on time. As you see, they are intrinsically connected to the money creation process in the economy. If many individuals failed to repay, it could trigger a serious financial crisis. In the real world, some banks keep more than what the reserve requires them to mitigate such risks.

Credit Creation formula

Total credit creation = original deposits x money multiplier

Where,

Therefore,

Limitations of credit creation

One of the main sources of money supply in an economy is the central bank. The central bank ensures that there is enough money circulating in an economy. It does so by relying on commercial banks' reserves. The reserves of commercial banks are an important factor when it comes to money supply as they contribute to the creation of credit, which is the creation of more money in the economy. Factors that limit credit creation include:

The amount of cash in the deposits

The number of cash deposited in a bank hugely affects the money supply in an economy. If the public decided to deposit more money in the bank than usual the bank would end up generating more money. On the other hand, a bank could create less credit if there were fewer deposits. This makes the amount of cash deposit a significant limitation to a bank's credit creation.

Reserve ratio

This is also known as the cash reserve ratio and it refers to the portion of deposits a bank is required to keep in its reserves to meet withdrawal requests. This is set by the central bank and it also serves as a tool to keep track of the money supply in the economy. The lower the rate, the higher the money supply.

Default risk

Banks may face limitations in the amount of credit they can create as they might need to select which customers they lend to. The reason for that could be that banks don't want to make a loan to someone incapable of paying back or might have an increased risk of paying back.

A default would cause huge losses for banks as they would also have to meet the deposits, which are an important liability for the bank.