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Study notes

Credit: How it is Created (Financial Economics)

  • Levels: A Level
  • Exam boards: AQA, Edexcel, OCR, IB, Eduqas, WJEC

This study note looks at the balance sheet of commercial banks and how they are able to create money through the process of credit creation.

Revision Video: How do Banks Create Credit?

How do banks create credit - revision video

Assets and Liabilities of a Commercial Bank

This is a basic model of the balance sheet of a commercial bank

Assets are “owned” by the bank

Liabilities are “owed” by the bank e.g. customers can walk into a bank or use an ATM machine to withdrawal some/all of their deposits

Assets

  • Cash
  • Balances at Bank of England
  • Loans (Advances)
  • Securities (e.g. Bonds)
  • Fixed assets

Liabilities

  • Customer deposits
  • Money owed to bond holders
  • Money owed to other banks

Structure of a commercial bank’s balance sheet

Key point: Bank deposits are simply a record of how much the bank itself owes its customers. So they are a liability of the bank, not an asset that could be lent out.

Key point: Reserves can only be lent between banks not lent to customers.

Assets and liabilities before and after bank lending

The Old Textbook View of Banks and Credit Creation

  • Banks take deposits of money from savers and lend it to borrowers
  • Banks then lend money to businesses, thus allocating funds between alternative investment projects

How Modern Commercial Banks Create Credit

  • Banks create credit by extending loans to businesses and households – pure and simple!
  • They do not need to attract deposits from savers to do this
  • When a bank makes a loan, for example to someone taking out a mortgage to buy a house, or a business taking out a loan to finance their expansion it credits their bank account with a bank deposit of the size of the loan/mortgage.

At that moment, new money is created!

“Banks making loans and consumers repaying them are the most significant ways in which bank deposits are created and destroyed in the modern economy.”

(Source: Bank of England)

Alternative (Stylised) View of a Bank’s Balance Sheet

Retail funding for banks

  • Retail funding remains the main funding source for UK retail commercial banks
  • Banks will typically pay a higher interest on retail deposits that are saved with a bank for a longer period of time. This give them a more secure source of funds.
  • The saver gets higher interest for sacrificing some liquidity.

The benefit to a bank attracting fresh deposits

  • Traditional economics teaching emphasised that banks could only lend out if they attracted new deposits from savers – this is UNTRUE!
  • By attracting new deposits, the bank can increase its lending without running down its reserves.
  • There is intense competition between banks and building societies for the retail deposits of individuals and businesses
  • But in recent years, the average interest rate on savings deposits has been historically low and usually less than the rate of consumer price inflation (i.e. real interest rates on savings have been negative)
  • Commercial banks prefer to attract stable deposits, i.e. deposits that cannot be withdrawn immediately as this helps them to control their “liquidity risk”.
  • Longer-term savings deposits therefore typically offer a higher rate of interest for savers, a reward for the inconvenience of sacrificing some of their liquidity

Limits to Money Creation by Commercial Banks

In a modern financial economy, there are a number of constraints that restrict the amount of money that banks can create:

  1. Market forces – the scale of profitable lending opportunities
  2. Regulatory policies e.g. capital reserve requirements
  3. Behaviour of consumers and businesses e.g. decisions about how much debt to repay
  4. Monetary policy - level of policy interest rates influences the aggregate demand for loans

Interest Rates on Consumer Loans in the UK

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