Commercial banks create credit primarily through a process known as fractional reserve banking, where they advance loans and purchase securities, effectively increasing the money supply beyond the initial deposits.
Understanding Credit Creation
Credit creation is the process by which commercial banks expand the money supply in an economy. Unlike simply acting as intermediaries that lend out existing funds, banks have the unique ability to create new money whenever they grant a loan or make an investment.
The Core Mechanism: Lending and Deposits
At its heart, credit creation occurs because a bank's loan to an individual or business isn't typically given out in physical cash. Instead, the loan amount is deposited into the borrower's account or another bank account. This new deposit, while a liability for the bank, becomes an asset for the borrower and effectively adds to the total money circulating in the economy.
Here's how it generally works:
- Initial Deposits: Commercial banks accept deposits from the public. These deposits form the base from which they can begin the process of credit creation.
- Advancing Loans: When a bank lends money to individuals or businesses, it doesn't give them cash from its vault that was directly deposited by someone else. Instead, the bank creates a new deposit account for the borrower or credits the loan amount to an existing account. This new deposit represents newly created money.
- Purchasing Securities: Similarly, when a bank purchases government bonds or other securities, it pays for them by crediting the seller's account. This action also results in a new deposit and thus, new money entering the system.
The Role of Fractional Reserve Banking
The ability of banks to create credit stems from the fractional reserve banking system. Under this system, banks are required to hold only a fraction of their total deposits as reserves (either in their vaults or at the central bank). The remaining portion, known as excess reserves, can be lent out.
This means commercial banks cannot use the entire amount of public deposits for lending purposes. A portion must always be kept aside to meet withdrawal demands and regulatory requirements.
The Money Multiplier Effect
The initial creation of credit doesn't stop with the first loan. The money from that loan is typically spent by the borrower, and those funds are then deposited into another bank. The second bank, in turn, keeps a fraction as reserves and lends out the rest. This cycle continues, leading to a money multiplier effect, where an initial deposit can lead to a much larger increase in the overall money supply.
Consider this simplified example with a 10% reserve requirement:
| Step | Bank | New Deposit Received | Required Reserves (10%) | New Loan (Credit Created) |
|---|---|---|---|---|
| 1 | Bank A | $1,000 | $100 | $900 |
| 2 | Bank B | $900 | $90 | $810 |
| 3 | Bank C | $810 | $81 | $729 |
| ... | ... | ... | ... | ... |
| Total | (All Banks) | $10,000 | $1,000 | $9,000 |
In this scenario, an initial $1,000 deposit can eventually lead to $10,000 in total new deposits (and thus money supply) and $9,000 in new loans or credit created throughout the banking system. The formula for the money multiplier is 1 / Reserve Requirement Ratio. For a 10% reserve requirement, the multiplier is 1 / 0.10 = 10.
Factors Limiting Credit Creation
While banks have the power to create credit, several factors limit this ability:
- Reserve Requirements: Mandated by the central bank (e.g., the Federal Reserve in the U.S.), these requirements dictate the minimum percentage of deposits banks must hold, thus limiting the amount they can lend.
- Cash Leakage: If borrowers withdraw cash instead of depositing it into another bank, the money exits the banking system, reducing the potential for further credit creation.
- Demand for Loans: Banks can only create credit if there is sufficient demand from creditworthy individuals and businesses to borrow money.
- Central Bank Policies: The central bank can influence credit creation through various monetary policy tools, such as adjusting interest rates (e.g., the federal funds rate) or conducting open market operations, which affect banks' reserves.
- Borrowers' Creditworthiness: Banks must assess the risk of lending. They will not grant loans if they deem the borrower unlikely to repay, regardless of available reserves.
Economic Impact
The ability of commercial banks to create credit is fundamental to modern economies. It facilitates investment, consumption, and economic growth by increasing the availability of funds. However, unchecked credit creation can also lead to inflation or asset bubbles, highlighting the importance of central bank oversight and sound banking practices.
