In prior posts I have made an attempt at explaining what money is. A common and popular tool in monetary economics is the money mulitiplier model which describes the relationship between commercial bank money and central bank money in a fractional-reserve banking system. This basic principle of macroeconomics, found in every standard economics textbook is unfortunately a fallacy, perhaps even the biggest one that the understanding of modern monetary economics entails.
It assumes as shown below that a client of bank A deposits 100 in his account and the bank now lends out 90 and keeps 10 as reserves if 10% is the minimum reserve requirement. The new loan will lead to more deposits and through an iterative process of lending out the new deposits the initial 100 will result in 1000 of commercial bank money. See more here.
My problem with this theory is that it ignores the process, which banks nowadays undergo to make a loan. It is much more compelling and comprehensive to think of it in the following way shown below. When a customer of Bank A asks his bank for a loan the bank will approve the loan if he is sufficiently credit-worthy. The bank will thus increase its balance sheet by extending the loan and at the same create the deposit at Bank A in client A’s name. The bank therefore makes a loan and simultaneously creates the liability/ the deposit. No reserves are needed in the first place to make a loan and neither are deposits. Deposits are nothing more than an accounting entry. Although this might seem unconventional it is well understood by the experts as Paul Tucker, Deputy Governor for Financial Stability, Bank of England in a spech on Money and Credit, says something identical:
“..Banks extend credit by simply increasing the borrowing customer’s current account … That is, banks extend credit [i.e. make loans] by creating money..”
Every commercial bank itself holds an account with its central bank where it can itself take out a loan. Making use of an overdraft at the central bank is similar to the central bank extending a credit to the bank. It does this by lending against the available collateral that the bank holds on its balance sheet. Using this overdraft facility a bank is able to obtain the required reserves as show in the figure above.
So if credit creation is technically not constrained by deposits and reserves there are considerable factors that a financial institution will take into account. It has to fund the loan on its balance sheet and at the same time make a profit. This is the true constraint for credit creation.
One very basic example should illustrate the mechanics behind this decision. Let us assume Customer A needs 50 of his loan to pay for goods which he purchases from Customer B who banks at Bank B. How does such a transaction work? Below in what I labelled Scenario A the outcome of that transaction is shown. We can now see that that BANK A on behalf of customer A transfers 50 to Bank B into the account of customer B. Customer B now has deposits of 50 in exchange for having sold goods to Customer A.
The mechanics to achieve this outcome are shown in the next three steps. First its important to note that these payments occur in payment system which the central bank oversees. Transactions are made using central bank money (reserves) and the daily amount far exceeds EUR 2.3trillion! in the euro payment system known as Target2. Using the aforementioned overdraft facility at its central bank it borrows 50 from the central bank and immediately transfers 50 to Bank B as shown in Step 1.
However these overdrafts have to be cleared by the end of the day so the bank now has to fund the 50 somehow. Ideally this will happen in the money market and the ease of doing so will as mentioned earlier influence its decision to grant a loan in the first place. Bank B which now has 50 in assets as well as the deposit of 50 from Customer B will realize that it actually does not want to hold 50 in low yielding reserves. In the money markets it can now offer these 50. Bank A is looking for these 50 as it needs to clear the central bank overdraft before the close of business. As depicted in Step 2 Bank B now provides a short term loan to Bank A transferring the 50 in reserves back to Bank A and recording this transaction as a short term loan to bank A which itself now has ST liability. The overdraft with the central bank is also cleared and the final balance sheets are as shown below in Final Step.
In summary, it’s important to realize that reserves are not a constraint on lending/credit creation as the money multiplier model would suggest. A much more realistic representation is the process shown above. When making a loan or buying an asset financial institutions ultimately have to conceive the true cost of making the loan which is tied to their ability to fund that specific asset while making a profit. The simple transaction above showed how many important factors are relevant to accomplish this.
Also while technically its correct to say loans create deposits its not quite that simple. Ultimately the quality of the asset is far more important in credit creation. Therefore emphasis should be placed on the quality of the asset which needs to be funded. This was written about here and here, and consequently demonstrates that money is collateral in our financial system.