3.3.1Why banks create money

The answer to the rst, or ‘why’, question begins with a recognition that banks are

private sector, prot-making organisations with obligations to shareholders to increase

prots over time. Thus they will always be looking for ways of expanding their balance

sheets provided this leads to extra prot. Look again at Table 3.3, which shows the

aggregate balance sheet of a large number of banks. Notice that assets are composed

of various forms of lending: to the personal sector, the commercial sector, the govern-

ment or the Bank of England. The liabilities side is dominated by deposits. Notice

also that we can express any class of asset as a proportion of total assets or liabilities

and remember too that in Chapter 1 we said that these ratios are arrived at as a matter

of deliberate choice and are assumed to represent portfolio equilibrium.

Box 3.3Loans create deposits in a multi-bank system

	Bank A
Assets		Liabilities

Notes and coin	C	Capital and shareholders’	funds	S
	b			f
Deposits at the central bank	D()	Customer deposits		D
	b			p
Loans to the public sector	L
	g
Loans to the general public	L()
	p

	Bank B
Assets		Liabilities

Notes and coin	C		Capital and shareholders’	funds	S
	b				f
Deposits at the central bank	D	()	Customer deposits		D	()
	b				p
Loans to the public sector	L
	g
Loans to the general public	L
	p

Box 3.3 helps us understand some of the basic principles in the money-creation

process. It shows the balance sheets of two commercial banks, A and B. Although

simplied, these are an accurate representation of the information in Table 3.3.

Firstly, on the asset side, we see that banks hold two essential sources of instant

liquidity, notes and coin (C) and deposits at the central bank (D). (The latter are the

bb

‘operational deposits’. ‘Cash ratio deposits’ are not relevant here and are omitted.)

The remaining assets are loans of some sort, which must be either to the government

or public sector (L) or to the M4 private sector (L). (In practice, these may be

gp

‘advances’ or they may be ‘investments’ – securities which banks hold, but these are

just different forms of lending.) On the liabilities side, the essentials are similarly

preserved. Liabilities are dominated by M4 private sector deposits of some form (D).

p

We have said that the balance (or ratio) between various assets and liabilities is

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Chapter 3 • Deposit-taking institutions

something which is likely to have been arrived at as an act of deliberate decision

by banks. One key ratio is what we shall call the reserve ratio, R. This is the ratio of

immediately available liquid assets to deposit liabilities. Thus R(CD) D. This

bbp

is a key ratio because the protability of the banking system depends upon banks

being able to make loans of varying terms to maturity while holding deposits of shorter

maturity (the maturity transformation principle that we discussed in 1.1.3).

Reserves:Banks’ holdings of notes and coin plusoperational deposits at the

central bank.

Reserve ratio:Bank reserves divided bycustomer deposits.

In order to do this, banks need to know that they can meet any demand from their

depositors for convertibility of their deposits into cash. This convertibility must be

instant for ‘sight’ or ‘demand’ deposits. (For retail banks, sight deposits can be as

high as 50 per cent of total sterling deposits.) Thus, protability demands the reserve

ratio be kept to a minimum while condence in the banking system requires that it

should never fall too low! Remember (see Table 3.4) that broad money is dened as

bank (including building society) deposits of the M4PS (D) plusnotes and coin held

p

by the M4PS (C). The money stock, MDC. The ability of banks’ behaviour to

pspp

inuence the money stock thus focuses upon their ability to cause changes in the

quantity of customer deposits (D).

p

Imagine now that a customer of an individual bank, A, applies successfully for a

personal loan. Until he begins to write cheques, i.e. to spend, nothing has happened

to the balance sheet. As the loan facility is used, however, two things begin to happen

simultaneously. The gure for loans begins to tick up as the customer’s borrowing

increases. At the same time, the gure for deposits at the Bank of England falls by

an equal amount as the recipients of the cheques pay them into their accounts at

different banks and the cheques are presented for payment at the issuing bank.

When the loan facility is fully used, the composition of assets will have changed.

Advances will be larger by the amount of the loan () and the bank’s operational

balances will be smaller by the same amount ().

Notice that the size of the balance sheet has not changed but its composition

and therefore the ratios have. As a result of the loan, Dis reduced. If (CD) D

bbbp

is the reserve ratio, then with Dunchanged, the ratio is reduced. Notice also that

p

since the bank charges interest on advances but gets none for its notes and coin

and a low rate on balances at the Bank of England, its operations are now more

protable. Expanding its lending in this way is, on the face of it, clearly in the bank’s

commercial interest.

Granted that the expansion of lending may be protable, how does it affect the

money supply? Remember that the money supply consists overwhelmingly of bank

deposits. Clearly, as far as our lending bank is concerned, nothing has happened to the

money supply. The changes have been entirely on the asset side of the balance sheet.

But remember that this change in the composition of assets came about because the

borrower usedhis loan facility. Operational balances were reduced (and advances

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