How Banks 'Create' Money

One of my elective subjects in the Degree Course in the College was Economics. One of the papers in Economics was Money and Banking. My most favourite chapter in this paper was ‘How Banks Create Money’. This heading caught my fancy at the first glance.

During my long stint in my Bank, i also created some money.

Now, what is money?

Money is a matter of functions four:
A medium, a measure, a standard and a store.

It is a medium of exchange, a measure of value, a standard of deferred payments and a store of value. It is a medium of exchange of goods and services, a measure of the value of these. It is also a standard of deferred payments. Besides being a basis of current transactions, money is also the basis of deferred payments. Accounts of deferred payments are maintained in terms of money and neither the creditors nor the debtors lose. Money is a store of value in that people can store surplus purchasing power and use it when they need. Purchasing power saved in the form of money is secure and the risk of it being destroyed is almost not there. 

A bank can be called a ‘money-shop’. In a textile shop, textile goods are bought and sold. The owner purchases the items and sells these to her/his customers. One can say that in the same way ‘money’ is bought and sold in a Bank. The actual term for what is bought and sold in a Bank is ‘credit’.  The concept of Banking is based on trust. The English word ’credit’ is derived from the Latin word creditus which means trust. A bank accepts deposits from one set of its customers and gives loans to another set of customers. The relationship between a Bank and its customers is that of creditor and debtor. A depositor is the creditor and the Bank is the debtor. In case loans, the bank is the creditor and the customer is the debtor.

For purchasing something, one has to pay money, usually currency notes. Currency notes are nothing but promises by the central bank of a country to pay the bearer, the amount mentioned in the note. In India, currency notes carry the words, “I promise to pay the bearer a sum of … “. Below this, is the signature of Governor of Reserve Bank of India.  (By the way, years ago, the wordings were ‘I promise to pay the bearer on demand a sum of …’. I do not know why the words ‘on demand’ were discontinued. Does it mean that if one goes to R B I, tenders a currency note and asks for the amount mentioned in it, can R B I say, “Come after 5 days?”) 

One can also purchase an item by giving a promise. A bank account is like a promise. A depositor has the promise of the bank that it will pay the depositor a certain amount. We purchase things or repay our debts by exchanging the promise of the Governor of Reserve Bank of India (currency notes) or the promise of our banks ( by issuing cheques).

A depositor has the right to withdraw her/his money at any time but the banker knows that all the depositors will not withdraw their money at the same time. This phenomenon is the fundamental feature of banking. Banks make use of this situation, use the depositors’ money to lend it out to entrepreneurs who need capital. Depositors are people who have money which they do not plan to spend immediately and who not wish to engage in industry or business. Borrowers are people who are entrepreneurs but have no money to use as capital. Indeed, entrepreneurs find that it is more profitable to borrow and invest in enterprises than to invest their own money in these. 

In simple terms, when a depositor comes for withdrawing his/her money with a bank, there would always be other depositors for depositing and some borrowers who come for repaying. So banking is basically iska topi, uska shar.

Currency notes are debt instruments of the central bank of a country. Deposit accounts are debts of commercial banks. Loan accounts are debts of the borrowers of a bank. Banks work by trading debts for debts. 

A bank cannot lend all the money that it receives as deposits. There is a requirement of ‘Cash Reserve’. Every country’s law requires that banks have to keep a specified percentage (called Cash Reserve Ratio or CRR) of deposits, with the central bank of the country. Reserve Bank of India, set up under Reserve Bank of India Act, 1934, is the central bank of India. (Central Bank of India is not the central bank of India; it is one of the commercial banks like say, State Bank of India or Axis Bank.) Bank of England and Federal Reserve Bank are the central banks of U K and U S A respectively.

In addition to CRR, banks in India have to keep aside a certain percentage of their deposits as Statutory Liquidity Ratio (SLR). As required under Banking Regulation Act, 1949, banks have to keep certain funds as ‘liquid assets’ in the form of cash at the Branches, Government Bonds etc. The purpose is to ensure that a bank should always have some liquid assets – cash and cash-equivalents which can be easily converted into cash – to meet its liabilities to its depositors.  The percentages of CRR and SLR are decided by the Reserve Bank of India. Funds in CRR and SLR are not available for lending. CRR and SLR are meant to ensure that a bank does not lend away all the money it collects as deposits.

Now how do banks create money? As a simplistic example, let us assume that the total deposit of a Bank A is Rs. 100 (deposited by Customer M) and it has to keep a total of 10% as CRR and SLR. Thus, equivalent of 90% of the deposits is available for lending. The bank lends Rs. 90 to Customer N. To meet his obligations, customer N issues a cheque for this amount to Customer P who deposits this cheque with Bank B. Bank B keeps Rs 9 (10% of Rs 90) as CRR and SLR and lends the remaining Rs. 81 to Customer C. Customer C deposits this amount of Rs. 81 in a bank, which lends keeps Rs. 8.1 and lends the remaining Rs. 72.90.    This process goes on till the funds remaining in the banking system becomes, equal to the total of CRR and SLR.

If we calculate at this stage, the funds in the banking system, with a deposit of Rs. 100, becomes Rs 343.90 (100 + 90 + 81 + 72.90= 343.90). Thus one can say that banks have created an additional amount of Rs. 243.90!       

This appears like jugglery! The whole system works on trust and credit. If the bulk of the borrowers fail to honour their commitments (promises), the system will start collapsing. But such a situation is highly unlikely and may happen only rarely. A few borrowers do default or fail to repay and banks have no alternative to write these off. This amount is comparatively low and goes to reduce the profit of the banks.

However, the preceding example is an over-simplified way of what actually happens.

Now, the original question: What is money?

If i go to Reserve Bank of India with a currency-note for Rs. 100, ask them to redeem the promise of their Governor and pay me the sum mentioned, what will they give? Money is an abstract concept. To say correctly, 'money' cannot be  seen or touched; money is purchasing power, a concept developed in society to facilitate exchange of value. It replaced the barter system which was an inconvenient and clumsy system of exchange.

TAIL PIECE:

It is easier to make money than to manage it!