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8.4: Money Created by Banks

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  • Banks create money when they increase their deposit liabilities to pay for the loans they make to customers, or for the financial securities they buy. The public uses the deposit liabilities of the banks as money to make payments or to hold as a store of wealth. The banks’ ability to create money comes from the willingness of the public to use bank deposits, the liabilities of the bank, as money. Thus, four key conditions that give banks the ability to create money are:

    1. The non-bank public has confidence in banks and is willing to hold and use bank deposits as money.
    2. The non-bank public is willing to borrow from the banks to finance expenditure or asset purchases.
    3. The banks are willing to operate with cash reserves equal to some small fraction of their deposit liabilities.
    4. The banks are willing to accept the risks involved in lending to the non-bank public.

    If any of these is absent, the banks cannot create money, although they may provide safekeeping services.

    The first condition is described and defined by the currency ratio (cr). That is the ratio of cash balances to the bank deposits that members of the non-bank public wish to hold. The banks hold the cash in the economy not held by the non-bank public. Banks acquire cash by offering customers deposit services, as we have discussed above. If the non-bank public holds all its money as cash, the banks cannot acquire the cash reserves they need to cover their deposit liabilities. There is no banking industry.

    Currency ratio (cr): the ratio of cash balances to deposit balances the held by the non-bank public.

    \(cr = \displaystyle\frac{\text{non-bank public cash holdings}}{\text{non-bank public bank deposits}}\)

    The third condition required for the banks to create money is a bank reserve ratio that is less than one. The reserve ratio (rr) is the ratio of cash on hand to deposit liabilities that banks choose to hold. We defined this ratio earlier as:

    \(rr = \displaystyle\frac{\text{reserve assets}}{\text{deposit liabilities}}\)

    Cash holdings are reserve assets. If banks choose to hold reserves equal to their deposit liabilities, rr = 1 and the banks cannot create deposits. They are simple safety deposit boxes.

    To see how banks can and do create deposits, we start with a very simple case. Let’s assume banks use a reserve ratio of 10 percent (rr = 0.10), and the public decides it does not wish to hold any cash balances (cr = 0). Suppose initially the non-bank public has wealth of $1000 held in cash, before they decide to switch to bank deposit money. This cash is a private sector asset. It is a liability of the central bank or government, which issued it, but not a liability of the private banks. The first part of Table 8.4 uses simple balance sheets to show this cash as an asset of the non-bank private sector.

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    Table 8.4: How the banking system creates money

    Then people deposit this $1000 of cash into the banks by opening bank accounts. Banks get assets of $1000 in cash, distributed among individual banks by their customers and issue total deposit liabilities of $1000. These deposits are money the banks owe to their depositors. If banks were simply safety deposit boxes or storerooms, they would hold cash assets equal to their deposit liabilities. Their reserve ratio would be 100 percent of deposits, making rr = 1.0. Table 8.4 would end with part 2.

    However, if the public uses bank deposits as money, the banks don’t need all deposits to be fully covered by cash reserves. It is unlikely that all depositors will show up at the same time and demand cash for their deposits. Recognizing this, the banks decide that reserves equal to 10 percent (rr = 0.10) of deposits will cover all net customer demands for cash. In this case, the many banks have excess reserves which in total equal 90 percent of their deposit liabilities or, initially $900.

    The banks use their excess reserves to expand their lending. Each bank makes new loans equal to its excess reserves. It pays for those loans by creating an equal amount of deposits. If you were to borrow from bank your personal deposit would be increased by the amount of the loan. The same thing happens to other people who borrow from their banks.

    In our example, all banks combined can create $9000 of loans based on $1000 in new cash reserves. In part 3 of Table 8.4, we see loans of $9000, as assets on the banks’ balance sheets, and $9000 of new deposits to customers, against which they can write cheques or make payments on line or by transfers. The deposits of $9000 are a liability on the banks’ balance sheets. Because the public uses bank deposits as money, the banks can buy new loans by creating new deposits.

    Now the banks have $10,000 total deposits—the original $1000 when cash was deposited, plus the new $9000 created by making new loans—and $10,000 of total assets, comprising $9000 in loans and $1000 in cash in the vaults. The reserve ratio is 10 percent in part 3 of Table 8.4 (rr = $1000 cash/$10,000 deposits = 0.10 or 10%).

    It does not even matter whether the 10 percent reserve ratio is imposed by law or is merely smart profit-maximizing behaviour by the banks that balances risk and reward. The risk is the possibility of being caught short of cash; the reward is the net interest income earned.

    Why were the banks able to create money? Originally, there was $1000 of cash in circulation. That was the money supply. When paid into bank vaults, it went out of circulation as a medium of exchange. But the public got $1000 of bank deposits against which cheques could be written. The money supply, cash in circulation plus bank deposits, was still $1000. Then the banks created deposits not fully backed by cash reserves. Now the public had $10,000 of deposits against which to write cheques. The money supply rose from $1000 to $10,000. The public was willing to use bank deposits as money, willing to borrow from the banks and the banks were willing to lend. This allowed the banks to create money by making loans based on their fractional reserve ratio.

    If the currency ratio is not zero the example is a bit more complex. The banks are still able to create deposits but the extent of the deposit creation is limited by the public’s withdrawal of currency to maintain the currency ratio as deposits increase. A fall in public confidence in the banks in times of financial problems and bank failures like those in that arose in the autumn of 2008 and continue today in some European countries would result in a rise in the currency ratio. Bank deposits and lending capacity would be reduced as a result.

    Financial panics

    Most people know that banks operate with fractional reserve ratios and are not concerned. But if people begin to suspect that a bank has lent too much, made high risk loans or faces problems in raising funds which would make it difficult to meet depositors’ claims for cash, there would be a run on the bank and a financial panic. Recognizing the bank cannot repay all depositors immediately, you try to get your money out first while the bank can still pay. Since everyone does the same thing, they ensure that the bank is unable to pay. It holds cash equal to a small percentage of its deposit liabilities and will be unable to liquidate its loans in time to meet the demands for cash.

    Financial panic: a loss of confidence in banks and rush to withdraw cash.

    The experience of the Northern Rock Bank in the U.K. starting in the summer of 2007 is an early example financial of panics that developed in the crisis of 2007 to 2009. Northern Rock was one of Britain’s largest mortgage lenders. It financed its lending with large denomination, short term wholesale deposits from other financial institutions like insurance companies and pension funds, as well as a relatively small amount of retail deposits from individual customers. As the recession and falling property values emerged the financial community began to worry that homeowners would not be able to pay back their mortgages.

    If that happened mortgage lenders like Northern Rock would not be able to pay back depositors money, especially the large denomination short term wholesale deposits. This loss of confidence in the value of and repayment of mortgages made current depositors unwilling to continue holding funds in Northern Rock. The risks involved were unknown. News of this collapse in its major source of funds triggered a loss of confidence among depositors, massive withdrawals and the first run on deposits in a British bank in about 140 years.

    Wholesale deposits: large denomination short term 30-day and 60-day deposits that pay higher interest rates than retail deposits.

    Despite substantial support from the Bank of England and government assurances that deposits were safe, depositors continued to withdraw funds and access to both commercial and retail deposits collapsed, as did the value of the bank’s shares on the stock market. In the end, the government, unable to find a suitable private buyer, nationalized the bank in order to prevent a bank failure that might spread to other financial institutions.

    Fortunately, financial panics involving depositor runs on the bank are rare, particularly in Canada. A key reason for this, which we discuss in the next chapter, is that the central bank, the Bank of Canada, and other national central banks, will lend cash to banks in temporary difficulties. Furthermore, deposit insurance plans like the Canadian Deposit Insurance Corporation, CDIC, cover individual bank deposits up to $100,000 against default. Knowledge of these institutional arrangements helps prevent a self-fulfilling stampede to withdraw deposits before the bank runs out of cash.

    However, recent experience shows how financial crises can arise in other ways. Northern Rock was the first casualty of the crisis in the U.S. mortgage market and real estate sector. Once portfolio managers realized that it was difficult if not impossible to evaluate the risks of wholesale deposits, financial institutions were in difficulties if they held those deposits or relied on renewing and issuing new deposits to raise funds. Several large financial institutions in the United States required government rescue or failed. The plight of famous names like Bear Sterns, Countrywide Financial, Fannie May, and Freddie Mac became headline news.

    The crisis was not limited to the U.S. financial sector. Banks in Iceland could no longer place new deposits to refinance their wholesale deposits and were taken over by the government. In late 2008 the large Swiss bank USB announced a bailout agreement with the Swiss National Bank to stabilize its financial position after continued difficulties based with its holdings of wholesale deposits. Other European lenders, including Bradford & Bingley in the U.K., and Fortis in Belgium and Luxembourg have been rescued by their governments.

    Banks in Canada were not immune to the financial difficulties created by the collapse of the commercial paper markets. All the major chartered banks were holding some of the commercial paper that contributed to the market collapse in 2008. They were forced to accept that without a market these assets had no value and funds tied up in them were lost. Fortunately, Canadian banks relied more heavily on strong retail depositor bases as sources of funds. The banks remained financially strong even after their commercial paper losses, and public confidence in the banks did not collapse. No Canadian bank failed or required a government bailout.

    By contrast, the financial crisis and the extended real estate and credit collapse created large problems for US banks. Loan and financial asset defaults destroyed bank assets and bank liquidity. Even in the absence of panics and bank runs, many banks become insolvent without sufficient liquid assets to cover their liabilities. Failed bank data illustrates the scale of the problem. The U.S. Federal Deposit Insurance Corporation lists 457 U.S. bank failures over the period January 2008 to September 2012. In the four preceding years, January 2004 to December 2007 there were just 7 US bank failures. (