Economics
Deposit Creation
Deposit creation refers to the process by which banks generate new money through the issuance of loans. When a bank lends money, it creates a deposit in the borrower's account, effectively increasing the money supply. This process is a key function of the banking system and has significant implications for the overall economy.
Written by Perlego with AI-assistance
Related key terms
1 of 5
9 Key excerpts on "Deposit Creation"
eBook - ePubCredit and Creed
A Critical Legal Theory of Money
- Andreas Rahmatian(Author)
- 2019(Publication Date)
- Routledge(Publisher)
31 but it does not explain properly the money creation process and should not be given too much emphasis.27 Bank of England (2014a: 14–15).28 Werner (2016: 370).29 Howells and Bain (2005: 241).30 Bank of England (2014a: 15).31 See e.g. Crowther (1946: 45). See also below under sec. 3(b).(c) Credit creation theory of moneyThe credit creation theory of money denies any correlation between money in depositors’ deposits and money provided by loans and therefore emphasises that banks do not use customers’ deposits to grant loans. In contrast, banks create money by giving credit: ‘Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money’.32 Banks are not financial intermediaries at all, neither individually (financial intermediation theory) nor in aggregate (fractional reserve theory). Schum-peter describes the money creation process in this way:33It is much more realistic to say that the banks ‘create credit’, that is, that they create deposits in their act of lending, than to say that they lend deposits that have been entrusted to them…. The theory to which economists clung so tenaciously makes [depositors] out to be savers when they neither save nor intend to do so; it attributes to them an influence on the ‘supply of credit’ which they do not have.The credit creation theory is not the newest of the three theories of money supply; it can rather be traced back to the nineteenth century and was only eclipsed by the other two theories, particularly after the Second World War. In the eighteenth century, ‘credit’ was still associated with moral ideas of ‘trust’ and ‘confidence’ between businessmen, not just with legal claim or debt, for example in the Essay on Credit by Pelatiah Webster of Philadelphia (1786):34
eBook - PDFEconomics
Theory and Practice
- Patrick J. Welch, Gerry F. Welch(Authors)
- 2016(Publication Date)
- Wiley(Publisher)
Although these loan‐making institu- tions include savings associations and credit unions, it is the commercial banks that are primarily engaged in money creation and destruction. Because of the huge impact that 2 Some economists write the equation of exchange as an identity: MV PQ . This equation is so classic that it was for years the license plate of a money and banking professor in St. Louis. 3 In reality, the velocity of money (M1) does change over time. However, in looking at the effect on the economy of increasing or decreasing the money supply at a particular moment in time, the assumption that V is fixed is appropriate. 206 Chapter 8 Money Creation, Monetary Theory, and Monetary Policy money supply changes have on the economy, it is important that the capacity of finan- cial institutions to make loans be highly controlled. This is one of the functions of the Federal Reserve. However, in order to understand how the Fed exerts its control over money supply changes, we need to understand under what conditions a financial depository institution can make a loan and how those conditions change. The Process of Money Creation Every financial depository institution has two assets that it counts as its actual reserves: the institution’s reserve account and its vault cash. Every institution must have a reserve account, which, as we saw in Chapter 7, can be held at a Federal Reserve bank or at an approved designated institution. Vault cash is all the cash in the depository institution’s vault and cash drawers. Depository institutions have a reserve requirement, which is a specific percent- age of deposits that must be kept as actual reserves. For example, a bank with a reserve requirement of 10 percent on demand deposits must have an amount on reserve equal to 10 percent of the value of the demand deposits it is holding.
eBook - PDFSovereign Money
Beyond Reserve Banking
- Joseph Huber(Author)
- 2016(Publication Date)
- Palgrave Macmillan(Publisher)
This may result in a balance sheet crisis rather than the rule reliably function- ing as a liquidity buffer. Seen from a bank’s point of view, all such restrictions in fact curb their potential for credit and Deposit Creation. However, the hindrance is short- rather than long-term. By cooperative credit and Deposit Creation, the bank- ing industry, supported by quasi-automated fractional refinancing of the central banks, creates for itself what it needs in order to extend the limits and fulfill the requirements, by building up equity, providing sufficient liquidity, acquiring enough collateral and so forth. The ‘masters of the universe’ will not create what it needs in six days and rest on the seventh. But they might be able to do it in seven months or a couple of years. As a result, the ability of the banking sector to extend credit and create bankmoney seems to be limitless in the long term. Not quite. As will be seen in chapter 5 on the dysfunctions of the bankmoney regime, real eco- nomic output will always be a gravitational limit that cannot arbitrarily be outsmarted. Banks and financial markets can overshoot that mark and in fact they recurrently do. It regularly proves to be unsustainable, resulting in vio- lent self-corrections of the markets, and in general crises causing damage to the entire economy and population. 4.9 Creation of Bankmoney: The Entire Picture So far, we have discussed how a bank creates bankmoney by making loans and granting overdrafts. It has not yet been discussed that banks also create bank- money when they purchase financial and real assets for their own account, such as securities, equity and real estate, also including office equipment, IT infrastructure, software, company cars, licences and so on, all items which are entered into the books as tangible or intangible assets. 24 Securities may gain or lose value, and the equipment and other durables are subject to scheduled write-down.
eBook - ePubThe Islamic Finance Industry
Issues and Challenges
- Burak Çıkıryel, Tawfik Azrak, Tawfik Azrak, Burak Çikiryel, Burak Çıkıryel, Burak Çikiryel, Tawfik Azrak(Authors)
- 2023(Publication Date)
- Routledge(Publisher)
Let’s assume, at time t =0, Trader A has $100 in cash. He lends out all this amount as he is not subjected to a required reserve ratio. After three steps, there is still $100 cash in the system, total loans created is $300, and the total amount borrowed is $300. If we compare this situation with the one in the banking system, the total loan amount is slightly higher (because of the absence of the required reserve ratio), and there was no Deposit Creation. As Menger (2009) pointed out, if a bank begins to decrease Deposit Creation, the gap would be immediately filled by a competing bank, or, if this is not possible, the commerce will create for itself other media of circulation to settle transactions, which will take the place of deposits (Menger, 2009). However, the most crucial difference between these two examples is that when banks grant loans and create deposits, this increases the money supply and disturbs the stability of the economy’s unit of account. In terms of money supply, at the end of the second example, the total cash amount still equals $100. However, at the end of first example, through money creation, total deposits amount is $346.61 that is readily to be spent. Figure 2.2 Creation of Loans by Traders. Source: Authors. For the deposit multiplication example of the banking system, we assume a cash amount of $100 is deposited in the first place. However, credit creation theory asserts that there is no need for that. A researcher conducted an empirical study with a local bank in Germany to see how banks channel funds for lending. The bank’s manager confirmed that neither he nor the bank’s staff checked either before or during the granting of the loan whether they keep sufficient funds with the central bank. Furthermore, the bank also did not undertake any transfers or account bookings in order to finance the credit balance (Werner, 2014). This phenomenon is peculiar to banks
- Dirk H. Ehnts(Author)
- 2016(Publication Date)
- Routledge(Publisher)
We’ve mentioned that banks promise to exchange deposits into cash one-for-one. How does this work in practice? 4 The creation of central bank deposits In most of today’s monetary systems, the monopoly for production of cash lies with the state. As we’ve seen above, in a pure credit economy there’s no need for cash. Even though today we handle the bulk of our transactions through transfers of bank deposits, we still expect banks to deliver cash to the full extent of our deposits, whenever we go and demand cash in exchange for a decrement of our deposit account. Since we do not get our cash directly from the central bank, the mechanism must be more complicated than is normally assumed. There are three essential mechanisms by which commercial banks can increase the amount of cash or deposits at the central bank. First, banks can increase their holdings of cash by borrowing directly from the central bank. Second, the central bank can influence the amount of central bank deposits held by banks through ‘open market operations’, i.e. by buying (or selling) illiquid assets and hence providing banks with more (or fewer) central bank deposits. The central bank usually does this in order to change the short-term interest rate. Or third, central bank deposits increase following an increase in fiscal spending. In this section we focus on the first two possibilities; the third is covered in the following section. Let’s have a more detailed look at the creation of bank depos- its first. bank firm loan 100 deposits 100 deposits 100 loan 100 The bank gave a loan to the firm, based on a debt contract between the two parties (i.e. between the bank and the firm). The bank creates deposits in its accounting software, which shows that the firm owns 100 in deposits. At the same time, the loan will be booked as an asset for the bank.
eBook - PDFMoney and Banking
Made Simple
- Ken Hoyle(Author)
- 2014(Publication Date)
- Made Simple(Publisher)
(Bank Β loses £446 to Bank A) 92 Money and Banking as cash. That holders of deposits do not attempt to turn them into cash indicates that businessmen and the public in general are prepared to accept the settlement of debts by the transfer of deposits—by the use of cheques. There is therefore no need to make a mass movement from deposits to cash. Bank deposits become 'credit' balances which a banker owes to his customers. Deposits will be owed because the banker has taken something from the depositor—currency, another bank deposit, securities (e.g. Treasury bills) or a claim upon the customer. Where a banker builds up deposits in exchange for cash or other de-posits the Deposit Creation is said to be passive since there is no net effect upon the supply of money. Where the deposits are created as a result of advances made against securities or a claim upon the customer, these crea-tions are termed active, since there will be a net addition to the money supply. Needless to say the process can work in reverse; what the banks have created they can also destroy. The total amount of money in circulation can be reduced by the destruction of actively created bank deposits (banks might have to do this if, for example, they are squeezed by governments). The de-struction of credit cannot be achieved quite as rapidly as credit can be created, for the customer to whom an advance has been made has a contractual arrangement which the bank cannot break at once. Any 'squeeze' applied to the banking system therefore operates to prevent the creation of any extra credit except for the most justifiable reasons. As repayments are being made day by day by all sorts of customers in the course of meeting their loan arrangements, this money will be withdrawn from circulation and the general money supply will be reduced as a result. The ability of banks to engage in active Deposit Creation rests upon public confidence in bank transfers as a method of payment.
eBook - PDFThe Money Revolution
How to Finance the Next American Century
- Richard Duncan(Author)
- 2022(Publication Date)
- Wiley(Publisher)
From that point, money began leaking out of com-mercial bank deposit accounts and moving into other kinds of products, often in search of higher returns. Afterwards, what had been a relatively straightforward pro-cess in which the private depository institutions created money and credit through the system of fractional reserve banking became more complicated. 178 Credit Bank deposits gradually ceased to be the most impor-tant source of funding for the financial sector because deposi-tors took their money out of banks and invested it in the other investment products that non-bank financial institutions began to offer them. The Creation of Non-deposit Liabilities by Commercial Banks The way the financial sector created money and credit evolved during the second half of the twentieth century. To understand this evolution, let’s first look at the commercial banks and the other private depository institutions to see how their pattern of extending credit changed. We will find that over this period the financial sector began lending relatively less to non-financial sec-tor end users of the funds, such as the federal government and state and local governments, and relatively more to other entities within the financial sector, thereby providing them with funds they could use to extend credit themselves. At the end of World War II, investments in US government bonds accounted for a full 72% of all the credit extended by the private depository institutions. Loans made up only 22% of their total portfolio of loans and investments. The composition of these institutions’ portfolios changed very rapidly after the war, however. By the early 1960s, the relative proportion of govern-ment bonds and loans in the private depository institutions’ port-folios had been reversed, with the former falling to below 20% of the total and the latter rising above 70%. Between the mid-1960s and 2007, loans continued to account for 70% to 80% of these institutions’ total assets.
eBook - PDF- John E. Marthinsen(Author)
- 2020(Publication Date)
- De Gruyter(Publisher)
Chapter 8 Money Creation Using money is such a routine part of our daily lives that it is easy to overlook the fact that the creation of money is a business , which is conducted by financial institutions to make profits. Therefore, when central banks regulate their na-tions ’ money supplies, they also regulate financial intermediaries ’ profits. This chapter discusses the money creation powers of financial intermediar-ies. Because most nations have a wide variety of them (e.g., commercial banks, savings banks, credit unions, and other thrift institutions), we will focus on those financial intermediaries that take deposits and make loans . As a group, we will call them “ banks. ” One of the best ways to understand the money-creation process and the power a single bank possesses to create money is by analyzing the effect a loan has on the bank ’ s balance sheet and the nation ’ s money supply. From this discussion, it is a natural step to discuss the money-creation powers of the banking system 1 and how it amplifies the powers of a single bank. In Chapter 9, “ Central Banks, ” this foundation will be vital to understanding how central banks regulate financial intermediaries and, thereby, control their nations ’ money supplies. The Basics Creation of Money by a Single Bank Banks have the power to change a nation ’ s money supply. They do so by mak-ing loans and purchasing securities because these bank assets are paid for with newly created checking accounts or with cash from banks ’ vaults. Let ’ s trace the effects that loans and security purchases have on a bank ’ s balance sheet and then show the impact these changes have on a nation ’ s money supply. Figure 8.1 shows the balance sheet of First National Bank before making a loan. Notice that total assets equal $10,000 million, and the sum of the bank ’ s liabilities plus stockholders ’ equity also equals $10,000 million.
eBook - ePubThe Production of Money
How to Break the Power of Bankers
- Ann Pettifor(Author)
- 2017(Publication Date)
- Verso(Publisher)
private banking system. Rather than banks acting as intermediaries and lending out deposits that were placed with them, it is the act of lending itself that creates deposits or bank money, and is also a debt, the Bank’s staff explained. Of course this bank money is not actually printed by the private bank; only the central bank has the legal authority to print money and mint coins. The money created by a loan – bank money – is simply digitally transferred from one private bank account to another. The only evidence of its existence is in the numbers printed on a bank statement. Of the total amount of money created, only a tiny proportion is normally converted into tangible money in the form of notes and coins, or cash.For private commercial bankers operating within a monetary economy, the relevant consideration is not the availability of existing savings, but the viability of the borrower, her project, her collateral and the assessment of whether the project will generate income with which she can repay the credit/debt.And yes, the Bank of England confirmed that in a monetary economy the money multiplier (the percentage of deposits that banks are required to hold as reserves against lending) is an incorrect account of the lending process. Bank lending is not constrained by ‘reserves’. The assumption that banks hold reserves equal to a fraction of their lending – ‘fractional reserve banking’ – is wrong. Bank ‘reserves’ are not savings in the sense we understand them. They are resources (resembling an overdraft) made available only to the bankers licensed by the central bank. They are used to facilitate the ‘clearing’ process for settling deposits and liabilities between banks at the end of each day. Central bank reserves never leave the banking system to enter the real economy. While central bank reserves may help to free up the balance sheets of banks and other associated financial institutions, they cannot be used to lend on to firms or individuals in the non-bank economy.
Index pages curate the most relevant extracts from our library of academic textbooks. They’ve been created using an in-house natural language model (NLM), each adding context and meaning to key research topics.
