How Banks Create Credit

How Banks Create Credit – Investment Policy
To summarize the phrase how banks create credit, we would then say that banks create credit in two major ways.
These methods on How Banks Create Credit includes the following;

  • By advancing loans
  • By purchasing securities

Every record of an advance issued by a financial institution or made by a bank creates a corresponding deposit. Money at call and short notice are extremely short period loan made by the bank to speculators and brokers in the money market and the capital market. The bank credits the deposit accounts of these speculators and dealer in exchange for their promises to repay at call short notice. These beneficiaries then use the deposits to pay off their creditors. The creditors in turn receive these cheques or drafts and credit them to their accounts hence as a result of loans have been created.

In the same manner, Bill discounted refer to the commercial and financial bills usually of short duration (+91 days) which the bank acquires as a form of investments. In acquiring or discounting a bill of exchange from party, it will credit the account of that party involved if it has an account with the bank or it will pay the party through a cheque drawn on itself. The party selling the bill will deposit the cheque in its bank account. In both cases, bank deposit will increase.

How Banks Create Credit And Circulate Funds

Banks advances or loans answers the question of How Banks Create Credit, they are made to investors and industrialist or businessmen of various trades. When a loan is approved, the bank creates a deposit in the name of the borrower and allows him to draw on this deposit to pay off his creditors. Thus every loan a bank makes is creating more deposits simply by making more and more loans and advances.

Finally investments are made by a bank when it purchases and holds government bonds and other securities whose maturities exceed three months. When banks make such investments, it places at the disposal of the seller a bank deposit which the seller can use (if government) in any way it likes. The bank deposit created for the seller in form of chequing power is deposited in some other banks and so credit is created.

From the account above it becomes clear that banks do not keep Naira for naira reserve against deposits in order to be able to meet depositors demands arising from their primary deposits. Rather these deposit are used to create further deposits after making some promise or undertaking to repay the depositor on demand and keeping a small reserve to be able to do so. In this way, a bank is enabled to erect a vast superstructure or credit on the basis of a small cash reserve.

Note also that every time a bank acquires an earning asset, it creates a deposit in he name of the person or the institution form whom the asset is purchased. The assets may be a promise to pay within three months or it may be a government’s IOU to be redeemed over a long period of time against these promise of individuals, institutions and government, which do not constitute money, the bank gives it own promise (in essence deposit) which is money hence a bank is said to monetize debt or create money.
Two points stands out here;

First, every asset acquired by a bank creates an equivalent bank deposit hence we are correct to say that bank loans create deposits, banks take the initiatives to give loans and advances and acquire other earning assets, and in so doing they control the total volume of deposit in the banking system.

Secondly, commercial banks monetize the dent of others. Against the promise of other to pay, the bank give their own promise to pay. The former isn’t money but the latter is in this sense banks create money. In answering the question of How Banks Create Credit, we can thus say that credit creation can be said to imply a situation where a bank may receive interest simply by permitting customers to overdraw their account or by purchasing securities and paying for them with its own cheques thus increasing the total bank deposit.

Techniques Of Credit Creation By Banks (How Banks Create Credit)

Consider the case of a community bank and say Ugwuegu community bank, which opens its business book with the following positions
Ugwuegu Community Bank Statement of Affairs As at 30th Jan 1999

  • Capital – 3,000000
  • Building – 2,000000
  • Futures and furniture – 500,000
  • Motor vehicles – 500,000

At this point the bank advertises for customers to come and open accounts and transact other full banking business with it, suppose a customer responds by depositing $100,000, in the bank saving account, the position will appear thus;

  • Capital – 3,000000
  • Deposit – 100,000
  • Building – 2,000000
  • Futures and furniture – 500,000
  • Motor vehicles – 500,000
  • Cash – 100,000

The deposit by the customer goes to increase the cash position of the bank as well as correspondingly creating a liability for the bank (since deposits are liabilities to the banks). The bank has to pay interest on this amount. Hence it must lend it out to some one else. Note carefully that this amount is never actually paid out to the borrower, on the contrary it is retained by the bank to meet its obligations, in essence to pay those of its depositors who need cash and thus draw cheques for that purpose. From experience of the bankers, they are able to identify that only a certain proportion of the cash reserve to total liabilities need be set aside.

Suppose further that the cash reserve percentage prescribed by the central bank for banks of such category is 20% in order to meet the demands of depositors. This mean that as soon as the Ugwuege Community Bank has receive  the $100,000 deposit it will decide to advance loans up to $500,000 (since one fifth of the reserve is kept) thus any business man with a good credit who enter the banking asking for a loan of $500,000 has a good chance of being accommodated. The bank would have further liabilities of $500,000 although it has only $100,000 in cash when the loans is given, a corresponding asset account is created known as loans and advances account thus;

  • Capital – 3,000000
  • Deposit (SD) – 100,000
  • Deposits (DD) – 500,000
  • Total = 3,600,000
  • Building – 2,000000
  • Futures and furniture – 500,000
  • Motor vehicles – 500,000
  • Loans and advance 500,000
  • Cash – 100,000
  • Total = 3,600,000

This transaction is possible because the borrower is not given the loan in cash, only an account is opened on his behalf and or the amount is credited to that account. He simply receives a chequebook, the right to draw cheques as and when he needs money. It has got but it is also true that a bank cannot lend more than what it has got, but it is also true that what is lent out by a bank may come back to the bank by way of new deposits which may again be let out so on thus deposit becoming the basis for a loan or investment which again returns to the commercial bank as fresh deposit and become a basis for a new loan.

Thus our follower, even when he withdraws cash, may have it deposited in another bank by himself or by his creditors who receive cheque payments from him. Thus various recipients are then credited. Cash is seldom withdrawn and the banks settle their mutual obligations through s system of bank clearing.

A small volume of the cash is the basis for the multiplication of deposits through multiplication of loans and advances, in essence “Loan and deposits”. It is in this sense that banks create credit. The community bank is able to create a credit of $500,000 against a cash reserve of $100,000.00.
Let us use a system perspective to illustrate this point further. Assume the following;

  • There a number of banks of W,X,Y,Z etc in the community each with different sets of depositors
  • Each of these banks keeps 20% of cash reserve as required by the monetary authorities
  • A new deposit of $1000 has been lodged with bank W to start with after the deposit is made in bank W, its balance sheet ( taking only the new transaction) will appear thus,

Bank W Balance Sheet

  • Liabilities – New deposit = $1000
  • Assets – New cash = $1000

Bank W has to keep 20% reserve in essence $200 against its new deposit, leaving it with a surplus of $800 which it can profitably employ, suppose this sum or excess reserve is lent to customer A who uses the money to settle his debt through the chequing system. After the loan is made and the amount is withdrawn. A”s balance sheet will indicate the following;
Bank W – Balance Sheet

  • Deposit = $1000
  • Total = $1000
  • Assets = – $200
  • Loan (X) = $800
  • Total = $1000

Suppose the creditor of A who received the $800 decide the deposit amounts with their banks in essence Bank X, the balance sheet of X will be as follows;
Bank X Balance Sheet

  • New deposit = $800
  • New cash = $800

After keeping a cash reserve of $160 (in essence 20% of 8000) bank X is free to lend the balance of $640 to anyone. Suppose further that it purchases bills worth $640, the new positions will be
Bank X balance Sheet

  • Deposit =$800
  • Total = $800
  • Assets = $160
  • Bills = $640
  • Total = $800

If the seller of the bills who received $640 from bank X decide to deposit in their bank in essence bank Y, the balance sheet of bank Y will as before indicate a new deposit of $640 and a new cash of $640. By keeping a cash reserve of 20% $640 in essence 128 only against a deposit of $6400, suppose bank Y buys long term government bonds from Mr C to the tune of $512, the new balance sheet position of bank Y will then appear thus.
Bank Y – Balance Sheet

  • Deposit = $640
  • Total = $640
  • Cash = $128
  • Bills = $512
  • Total = $640

Mr C may decide to deposit his $512 with his bank in essence bank Z which in turn may keep 20% as cash reserve and led out the rest. This process of a deposit becoming a loan or an investment etc will continue until the original deposit of $1000 is completely exhausted. The original deposit of $1000 becomes additional deposit of $800, $640, $512, $41, $328 etc, when these deposits are summed the total will be approximately, $5000 and this illustrated the process of deposit multiplication in credit creation expansion.

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