How banks create credit

Tim Bennett explains how credit is created, what the 'money multiplier' is, and how fractional reserve banking works.

Tim Bennett explains how credit is created, what the 'money multiplier' is, and how fractional reserve banking works.

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Should we ring-fence the banks?

A beginner's guide to how credit creation works.

  • What the money multiplier is
  • How does fractional reserve banking work?
  • What is credit creation
  • When people talk about the money you supply, what do they mean?

A hypothetical scenario here:

The bank then makes a calculation and decides to keep £10 back as a precaution, in case you wanted to withdraw some money at some point soon, as it's unlikely that you would want to withdraw all the money in one go.

The bank would then use the remaining £90 to earn credit. The bank could lend the £90 as an IOU to another customer. This customer uses this money to trade and spends it all. The person they traded with deposits their newly gained £90 back into the back.

The bank then keeps back a £9 deposit from the £90, and lends out £81 and so on.

If you carried on this process you could work out how much credit the bank could create from one deposit of £100. From a 10% retention ratio the bank could effectively create £1000.

If you change this to the bank keeping £20 back from the £100, the bank could only generate £500 credit.

The rate the bank decides to use to determine what proportion of the £100 deposit it's going to keep or lend out, determines how much credit will be created from the original deposit.

Economists use the following formula to calculate how much credit banks will earn:

1/R, where R is the rate.So if R = 10%, then £100/0.1 = £1000.If the deposit is 20%: £100/0.2 = £500

And so on.

This is the essential basis of fractional reserve banking.

The biggest problem with this is that it relies on confidence; it relies on the bank judging that 10% is the right ratio. It relies on people not demanding all their money back at once from the bank, and the whole banking system is built on that basis. You're entitled to withdraw all your money at once, but banking works on the premise that you won't want to.

This also flags a series of queries:

  • How central banks influence the supply of money in an economy
  • Economists would ask what you mean by money. Someone could say there is only the £100 that you began the example with. Others would say the total sum is that of your £100 + the £90 leant from the £100, if the money supply is potential spending power.

The role of central banks:

Three tools that can be used to influence what's going on in this example if you're a central bank:

  1. The discount rate:In short, there are IOUs out there that don't carry an interest rate. The way a central bank can influence that is through the following:In order to have a £1000 in a year's time, if interest rates are at 5%, you would only need to deposit £952 now. And there are financial instruments out there, IOUs, bonds that don't carry an interest rate, you buy them at one price and cash them in at another. They're called discount instruments. The price is influence by money market interest rates. Central banks can influence the size of the discount rate, of £1000 from £952.
  2. Change the reserve rateIf you up the reserve rate from 10 to 20%, you shrink your monetary base. It's a pretty blunt tool, it's not done very often that way. Under fractional reserve banking, the fraction matters.
  3. Open market operationThis is used most often and boils down essentially to buying and selling bonds.The other way you can influence the money in a central bank is buy buying and selling government IOUs. If you sell a lot of government IOUs people want to buy them because they're safe, they're a nice place to put your money. You sell IOUs, commercial organisations and banks bid for them, that suck money out of the banking system into the central bank, reducing the supply of money in the economy, because that money has been sued to pay for these IOUS, and if there's less money in the economy, the price will change, and the theory is that interest rate will rise.Alternatively if the go via central bank decides to start buying back these IOUs, that will release these central bonds into the economy, so in theory there is more money flowing around the economy, and will push the price down, so that will tend to reduce the price of money and reduce interest rates.

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.