Banks create money out of thin air. It is a by-product of their quest for profit. The entire economy thrives (and occasionally, falls too) on this ability of ‘credit creation‘ by ‘money factories‘. How do banks create more money than actually exists? How does this enable an increase in total volume of money in the economy? What are the risks?
First, let’s get on the same page with some basics:
- Banks get money from what we deposit in them.
- Deposits are banks’ liabilities, since banks must return it to us when we ask for the money.
- Banks lend loans by using this deposit money of ours.
- Loans are bank’s assets.
Reserve Bank of India (RBI) is the central note issuing authority in India. Commercial Banks in India are required to hold a certain proportion of their deposits in the form of cash. This minimum ratio (that is the part of the total deposits to be held as cash) is stipulated by the RBI and is known as the CRR or Cash Reserve Ratio. It is a tool used by RBI to control liquidity in the banking system.
Let’s assume there are various Banks in the Banking System. Bank_1, Bank_2, Bank_3, etc. Let’s assume the CRR to be 10%.
- Anand deposits Rs. 100 in Bank_1. Keeping Rs. 10 in reserve (CRR is 10%), Bank_1 lends Rs. 90 to Bala.
- Bala deposits his Rs. 90 in Bank_2. Keeping Rs. 9 in reserve, Bank_2 lends Rs. 81 to Clara.
- Clara deposits her Rs. 81 in Bank_3.
This process continues.
The Math Behind This:
Time for some calculations. In the first cycle, the bank could loan out 90% of Rs. 100. In the second cycle, the bank could loan out 90% of 90% of Rs. 100. Thus the amount of money the bank can loan out in some period n of the cycle is given by:
Rs. 100 * (90%)n
- Let A be the amount of money infused into the system (in our case, Rs. 100)
- Let R be the required reserve ratio (in our case 10%).
- Let T be the total amount the bank loans out
- Let n represent the period we are in.
From the equation above, the amount of money the bank can loan out in any period is:
A * (1 – R)n
Thus, the total loan amount is:
T = A*(1 – R)1 + A*(1 – R)2 + A*(1 – R)3 + …
T = A * [ (1 – R)1 + (1 – R )2 + (1 – R)3 + … ]
x1 + x2 + x3 + x4 + … = x / (1-x)
T = A * (1 – R) / R
How much money have our banks loaned out using the Rs. 100 deposited initially? Using the above equation, this would total up to 100 * (1 – 0.1)/0.1 = Rs. 900.
In this entire process, to find the total amount deposited (D), we need to take into account the initial Rs. 100 too.
D = A + T
D = A + [ A * (1 - R) / R ]
D = A * (1/R)
which, for our example, will total to Rs. 1000.
The cash in reserve for any period is:
R * A * (1 – R)n-1
Total reserve is:
( R * A ) [1 + (1 – R)1 + (1 – R)2 + (1 – R)3 … ]
which simplifies to A = Rs. 100
The Balance Sheet:
This is how the combined balance sheet of the Banks will look like:
|Bank||Liabilities Deposits||Assets Credits||Reserve||Total Assets|
Such is the power of this simple process that banks have created an asset of Rs. 1000 using an initial money of Rs. 100. In other words, Banks have created money. This type of banking is called “Fractional Reserve Banking”
Why does this process succeed?
This process succeeds because most money transfers today do not involve cash or currency. It involves just cheques, DD, etc. or electronic transfer – mere numbers on a computer screen.
When would it fail?
This system fails in two main cases:
- Cascade of withdrawals
When all depositors come asking for their money back at the same time. The banking system will not have enough currency to meet the demands. In fact, one main purpose of the CRR is that the banks must be able to repay deposits when there are significantly large number of withdrawals.
- Loan defaults
What would happen when the debtors default or fail to repay the loans? This would also result in banks having insufficient money to pay back depositors.
The financial system is much more complicated than what we have discussed. But the above two are one of the basic reasons for the recent recession – just that it involved a cascade of selling stocks on the market, and defaults of subprime mortgage loans.
The key thought here is:
Cash or Currency refers to the physical notes in our purses. Money, on the other hand, is a symbol of promise or trust (I promise to pay the bearer the sum of …). While cash is limited in an economy, money is unlimited.
Featured image: Saad Akhtar (Flickr)