What is Credit Creation?

Introduction

Money is any item or verifiable record that is generally accepted as payment for goods and services and repayment of debts, such as taxes in particular country or social economic context (Mishkin, 2007).

The main function of money are distinguished as: medium of exchange, store of value, unit of exchange and sometime referred as standard of differed payment.                                        

 Money is any good that is widely used and accepted in transactions involving the transformation of goods and services from one person to another (Johnson, 2006).

What is Credit Creation?

It is an open secret that the banks do not keep cent per cent reserve against deposits in order to meet the demands of depositors, (John,2007).

The bank is not a cloak room where you can keep your currency notes or coins and claim those very notes or coins back when you desire. It is generally understood that money received by the bank is meant to be advanced to others. A depositor has to be content simply with the bank’s promise or undertaking to pay him back whenever he makes a demand, (Apel, 2007).

This bank is able to do with a very small reserve, because all the depositors do not come to withdraw money simultan­eously; some withdraw, while others deposit at the same time. The bank is thus enabled to erect a vast superstructure of credit on the basis of a small cash reserve. The bank is able to lend money and charge interest without parting with cash. The bank loan creates a deposit or, as we have seen above, it creates a credit for the borrower.

Similarly, the bank buys securities and pays the seller with its own cheque which again is no cash; it is just a promise to pay cash. The cheque is deposited in some bank and a deposit is created or credit is created for the seller of the securities. This is credit creation.

Thus, term ‘credit creation’ implies a situation, when “a bank may receive interest simply by permitting customers to overdraw their accounts or by purchasing securities and paying for them with its own cheques, thus increasing the total bank deposits, (Baeriswyl, 2017).

Limitations on Credit Creation:

From the account of credit creation given above, it would seem that the banks ‘reap where they have not sown’. They advance loans or buy securities without actually paying cash. But they earn interest on the loans they give, or earn dividends on the securities they purchase, all the same. This is very tempting. They make profits without investing cash. They would, of course, like to make as much profit, like this, as they can, (Kurgan,2000)

But they cannot go on expanding credit indefinitely. In their own interest, they have to apply the brake and they do actually apply it, for it is well known that the profits made by the banks are not very high. The overriding limitation arises from the obligation-of the banks to meet the demands of their depositors, (Kurgan,2000).

The three limitations on the powers of the banks to create credit:

 (i) The total amount of cash in the country;

(ii) The amount of cash which the public wishes to hold; and

(iii) The minimum percentage of cash to deposits which the banks consider safe.

The way central bank create money.

creating central bank reserves

The banks use to make payments to other banks. Central bank reserves are one of the three types of money, and are created by the central bank in order to facilitate payments between commercial banks, (Stephen,2007).

In the following example we will show how the central bank creates central bank reserves for use by a commercial bank, in this case RBS. Initially the bank of England’s balance sheet appears as so (this is a simplified example where we’ve ignored everything except this particular transaction): 

RBS’s shareholders have put up £10,000 of their own money which has been invested in government bonds. So RBS’s balance sheet is, (Stephen,2007).

 As a customer of the central bank, RBS contacts the central bank and informs them that they would like £10,000 in central bank reserves.

For the purposes of this example it will be assumed that the Bank of England purchases the gilts from RBS outright. Once the sale is completed the Bank of England has gained £10,000 of gilts, but it now has a liability to RBS of £10,000, which represents the balance of RBS’s reserve account, as so, (Mary,2008).

The Bank of England’s balance sheet has ‘expanded’ by £10,000, and £10,000 of new central bank reserves have been created, effectively out of nothing, in order to pay for the £10,000 in gilts.

However, from the point of view of RBS’s balance sheet it has simply swapped £10,000 in gilts for £10,000 in reserves:

RBS’s balance sheet has not expanded at all; it has simply swapped one asset for another, without affecting its liabilities. RBS can now use these reserves to make payments to other banks, as described below.

 The central bank could alternatively lend RBS the reserves (in this case the assets side of the central bank’s balance sheet would show a £10,000 loan to RBS rather than £10,000 of gilts and the RBS balance sheet would show the new reserves as an additional asset on top of its holdings of gilts, and its obligation to repay the loan as an additional £10,000 liability), (Mary,2008).

Sale and repurchase agreements (repos)

However, the standard method by which the Bank of England creates reserves is through what is known as a sale and repurchase agreement (a repo), which is similar in concept to a collateralized loan. Essentially RBS sells an interest in an asset to the central bank (usually a gilt) in exchange for central bank reserves, while agreeing to repurchase its interest in said asset for a specific (higher) price on a specific (future) date. If the repurchase price is 10% higher than the purchase price (i.e. 10% higher than £10,000 = £11,000) then the ‘repo rate’ is said to be 10% (Mary,2008).

A repo transaction has different accounting rules from an outright sale. The Bank of England balance sheet would not show the gilts as the asset balancing the reserves, but the value of the interest in the gilts (valued at the £10,000 paid, not the £11,000 promised), whilst RBS would retain the gilts on its balance sheet in addition to the central bank reserves but record as an additional liability its £10,000 obligation to complete its end of the repurchase agreement. The extra £1,000 does not appear on either balance sheet but, when paid, is recorded as revenue (profit) for the Bank of England and an expense (loss) for RBS (Stephen,2007).

You may ask where does RBS get the money to pay the repo rate? – i.e. the interest on the repo. The Bank of England actually pays a rate of interest on central bank reserves equals to the repo rate – so if RBS borrows £10,000 using a repo at 10% it must repay £10,000 plus £1,000 in interest. Prior to RBS’s repayment the Bank of England pays interest on the reserves at 10%. This gives RBS £1,000 extra reserves which it must promptly use to repay the outstanding £11,000.

Whilst this process may seem a bit of odd, there is actually a good reason for paying interest on reserves in this manner. First, it means that banks are not penalized for holding reserves – having to borrow reserves at interest but not receiving interest on them meant that banks would be effectively charged for holding reserves. Correspondingly, it means that banks will not try to minimize their holdings of reserves. Before the Bank of England paid interest on reserves banks would attempt to hold as few as reserves as possible, which could pose a problem for settling payments.

Secondly, and most importantly by controlling the rate of interest paid on reserves, as well as the interest rate it charges banks to borrow in an emergency (it charges a premium interest rate on reserves lent through its ‘overnight lending facility’), the Bank of England creates a ‘corridor’ around its desired Policy (interest) rate. This ‘corridor’ allows it to set the interest rate at which banks lend to each other on the interbank market.

For example, if the rate paid on deposits is 4%, and the rate charged on emergency lending is 6%, normally a bank will never lend reserves to another bank at a rate of interest below the rate it could receive from depositing its reserves at the Bank of England (4%), or borrow reserves from another bank at a rate of interest higher than it could borrow from the Bank of England (6%). Because of this the interest rate banks will be willing to lend reserves to each other on the interbank market will be around 5%. (However today, due to the excess reserves in the system from Quantitative Easing, most banks have too many reserves, and as a result the central bank is setting interest rates through a ‘floor’ system) (Stephan,2007).

Generally, credit creation it is an open secret that banks advance a major portion of their deposits to their borrowers and keep smaller part of them for the payment to the customers on demand. Even customers of the banks have full the confidence that their deposits lying in the banks are quit safe and can be withdrawn on demand.

References

Stephan Quinn, and William Roberds. 2007 “The bank of Amsterdam and the leap to central bank   Money.” American Economic Review, 97 (2).

Goetzmann, William N.; Rouwenhorst, K. Geert (2008). The history of financial innovation, in  Carbon Finance.

Kurgan-van Hentenryk, Ginette. Banking, Trade and Industry: Europe American and Asia from 19^th  to 20^th century, Combridge University press, 1997, p.39

Mishkin, Frederic S. (2007). The Economics of money, Banking, and Financial Markets (Alternate   Edition). Boston: Addison Wesley. P.8.

John Goodman, Monetary Sovereignty: The Politics of Central Banking in Western Europe, Cornell University Press, 2001