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Credit Creation Theory of Banking

I. Credit creation:
Credit creation means that on the basis of primary deposits commercial
banks make loans and expand the money supply. It results in multiple
expansion of banks demand deposits.

• It is an open secret that banks advance a major portion of their deposits

to the borrowers and keep smaller part of them for the payment to the
customers on demand.

• Even then the customers of the banks have full confidence that their
deposits lying in the banks are quit safe and can be withdrawn on
demand.

• The banks exploit this trust of the customers and expand loans several
times than the amount of demand deposits possessed by them.

• “This tendency on the part of the commercial banks to make loans

several times of the excess cash reserves kept by the bank is called
creation of credit”.

II. What is Money:

Money within the economy can take several forms. Cash (notes and coins)
accounts for only 3% of the money in circulation, whilst the remaining 97% of
the money in circulation within the United Kingdom economy comprises of
credit money that has been created by banks (Ryan-Collins, Greenham,
Werner, & Jackson, 2011).
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Total money (including money created by banks) in relation to

cash in circulation
2,500

2,000

1,500
£ billions

1,000
Bank deposits
500

0 Notes and coins in circulation

30 Jun 02
30 Jun 99

30 Jun 05

30 Jun 08

30 Jun 11

30 Jun 14

30 Jun 17
31 Dec 97
30 Sep 98

31 Mar 00
31 Dec 00
30 Sep 01

31 Mar 03
31 Dec 03
30 Sep 04

31 Mar 06
31 Dec 06
30 Sep 07

31 Mar 09
31 Dec 09
30 Sep 10

31 Mar 12
31 Dec 12
30 Sep 13

31 Mar 15
31 Dec 15
30 Sep 16
Cash (notes and coins in circulation) in sterling billions [LPQVQKT / 1000]. Bank Deposits

Source: Bank of England (Bank of England, 2018)1

As previously stated, cash (bank notes and coins) account for approximately
3% of the money in circulation. Bank notes account for approximately 94% of
the total cash in circulation, whilst coins account for the remaining 6% of cash
in circulation.
Central bank reserves refer to commercial bank reserves that are held at the
central bank (Bank of England in the United Kingdom), which are presented in
the central bank’s electronic record of the amount owed by the central bank to
each commercial bank to facilitate large scale payments between commercial
banks. Central bank reserves are used to settle net amounts owed between
commercial banks at the end of each working day. Central bank reserves do
not circulate in the wider economy outside of the banking system, and so are
not considered when presenting the total amount of money circulating within
the economy. However, the central bank will convert electronic central bank
reserves into physical notes and coins that circulate within the economy, at the
request of a commercial bank. Commercial banks will request this conversion
of central bank reserves into cash (bank notes and coins) when commercial
banks require additional cash to satisfy the general publics demand for cash.
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Central bank money, which is also referred to as base money, comprises of

both cash and central bank reserves.
Bank deposits account for approximately 97% of the money supply in the
United Kingdom economy. Bank deposits are sometimes referred to as ‘credit
money’, because the majority of bank deposits were originally created by
banks issuing new loans.A bank creates credit money when generating a bank
deposit that is a consequence of fulfilling a loan agreement, extending an
overdraft facility, or purchasing assets. Credit money represents the total
amount of money that is owed to banks by borrowers. Credit money is
sometimes referred to as fountain pen money, because it is created with a
stroke of a banker’s pen (or more usually today, by inserting numbers into a
computer). The term credit money is a consequence of commercial bank’s IOU
only remaining valid whilst the bank remains solvent. Bankruptcy of a bank
would destroy a significant proportion, if not all, of the credit money created
by a bank. The credit money component of money supply is reduced when
money borrowed from a bank is repaid.
Bank deposits represent an IOU between a commercial bank and their
customers, with customers including both individuals and organisations. Bank
deposits can take a variety of forms, including current and deposit accounts.
However, the government guarantees through the Financial Services
Compensation Scheme the first £85,000 of an individual’s bank deposits, which
can be considered to be money due to the government guaranteeing
repayment of the money. Therefore, the term credit money only strictly
applies to the amount of an individual’s deposits with a bank that exceeds the
£85,000 limit of the Financial Services Compensation Scheme.

III. Credit Creation Theory of Banking

Whilst most textbooks discuss the money multiplier theory of credit creation,
there is limited consideration within academic textbooks of the credit creation
theory of banking. However, the Bank of England recently issued a paper which
recognises the credit creation theory of banking as a useful theory for
understanding the process of money creation (McLeay, Radia, & Thomas,
2014).
Credit creation theory of banking proposes that individual banks can create
money, and banks do not solely lend out deposits that have been provided to
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the bank. Instead, the bank creates bank deposits as a consequence of bank
lending. Consequently, the amount of money that a bank can create is not
constrained by their deposit taking activities, and the act of bank lending
creates new purchasing power that did not previously exist. The repayment of
existing debt destroys money, as a consequence of reducing bank loans
(assetside of balance sheet) and customer deposits (liability side of the bank
balance sheet).
A bank’s ability to create new money, which is referred to as ‘credit money’, is
a consequence of a range of factors.Firstly, non-cash transactions account for
more than 95% of all transactions conducted within the economy, with non-
cash transactions beingsettled through non-cash transfers within the banking
system. Banks’ ability to create credit money arises from combining lending
and deposit taking activities.Banks’ act as the ‘accountant of record’ within the
financial system, which enables banks to create the fiction that the borrower
deposited money at the bank. Members of the public are unable to distinguish
between money that a bank has created, and money saved at the bank by
depositors.
Banks’ ability to create credit money is also a consequence of being exempt
from the ‘client money rules’. Regulations in the form of the client money
rules prevent non-bank organisations creating credit money, because non-
bank organisations (for example, stockbrokers, solicitors and accountants) are
required to keep clients’ money separate from the non-bank organisation’s
assets and liabilitieson their balance sheet. However, banks’ exemption from
the client money rules enable banks to relabel liabilities on their balance sheet
at different stages of the process when extending a loan, which enables banks
to expand their balance sheets (Werner, 2014). Exemption from the client
money rules enables banks to rename their account payable liability as a
customer deposit, despite the money notbeing a consequence of a customer
making a deposit. There is no law, statute or banking regulation that allows
banks to reclassify their bank liabilities (accounts payable) as a fictitious
customer deposit. Consequently, the legality of banks creating credit money is
unclear. Banks exemption from the client money rules also means that when a
customer deposits money at their bank, the customer no longer owns the
money and becomes a general creditor of the bank.
The following process represents the bank’s accounting entries associated with
provision of a loan. The initial step is associated with the bank agreeing a loan
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with a customer, and the accounting treatment for the loan is the same
approach followed by any other type of financial intermediary.

The accounting entries associated with second stage of the process, when the
bank places money into a borrower’s bank account, is the point at which the
bank’s accounting treatment of the loan differs from other types of financial
intermediary. A bank creates new credit money as a consequence of their
accounting treatment of liabilities. The bank ledger converts the account
payable arising from a bank’s lending activity to a customer deposit, where the
customer deposit represents another category of bank liability. This accounting
process causes the bank to create a new customer deposit that was not
previously paid into the bank, but instead represented the reclassification of an
account payable liability of the bank. This accounting treatment of the
transaction enables the bank to expand both sides of their balance sheet at the
same time when making a loan.

Seigniorage traditionally refers to the profit received by the central bank from
creating new money, and is calculated as the difference between the cost of
producing physical money and the purchasing power of the newly created
money in the economy. For example, a £10 note can purchase £10 worth of
products within the economy, but only costs a few pence to produce.
However, given that commercial banks create the majority of money in an
economy, we can also calculate commercial bank seigniorage acquired from
bank credit creation. Credit creation increases bank profitability in two ways.
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Firstly, bank credit creation increases the volume of profitable bank lending
opportunities the bank can conduct. Secondly, bank credit creation reduces
the bank’s cost of capital, where the average interest rate paid on depositors’
balances that have been created by the bank is lower than the commercial
market interest rate paid on bank debt that would otherwise have to be used
to facilitate additional bank lending. It is estimated that commercial bank
seigniorage profits from credit creation that arose from loweringbanks cost of
capitalgenerated commercialbanks an annual £23 billion of addition profit per
annum during the period 1998 to 2016 (Macfarlane, Ryan-Collins, Bjerg,
Nielsen, & McCann, 2017, p. 2). Whilst state seigniorage profits from issuing
bank notes are estimated to have generated approximately £1.2 billion per
annum. Commercial bank seigniorage profit (CBS) is calculated using the
following formula (Macfarlane, Ryan-Collins, Bjerg, Nielsen, & McCann, 2017,
p. 18):
CBS = CBD (imb – id)
Where:
CBD = Commercial bank deposits
imb= commercial benchmark market interest rate
id = interest rate paid by banks on depositors’ money
Bank lending is determined by the existence of profitable lending
opportunities. Bank lending activity is influenced by the demand for bank
loans. Richard Werner proposes that Say’s Law can be applied to credit
creation, because increasing the supply of credit creates its own demand.
Lending secured on dwellings accounts for 49.6% of total United Kingdom bank
lending in 2017. The consequence of creating new money to purchase an asset
that is fixed in supply, such as property, promotes rising property prices that
will encourage greater demand for borrowing to purchase property2.
Bank lending activity is constrained by the need to remain profitable. Bank
profitability is a consequence of interest received on loans exceeding interest
charges on bank liabilities (which includes the interest paid on money
deposited at the bank, interest received by bank bondholders, and dividends to
bank shareholders). The difference between interest received on bank loans
and the bank’s cost of capital is then used to cover the bank’s cost of
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provisions for bad and doubtful debts and operating costs of the bank, and the
remainder is bank profit.
Banks money creation capability is constrained by their motivation to ensure
there is an appropriate spread between the interest rate received on money
loaned, and the cost of bank capital. A rapid expansion of bank lending will
require the bank to reduce the interest rate charged to borrowers, which will
reduce bank profitability. A bank must also ensure that it has sufficient
provisions and capital to cover unanticipated losses arising from bad and
doubtful debts, whilst also meeting regulatory requirements.
Creation of ‘credit money’ is determined by acommercial bank’s confidence
that issued loans will be repaid.Therefore, banks perception of ‘credit default
risk’is an important factor influencing the amount of bank lending.Strong
growth in property prices over a prolonged period of time reduces bank’s
perception of the level of credit default risk associated with property lending,
because money owed as a consequence of the borrower’s failure to repay a
loan will be recovered by the bank repossessing the property that provided
security for the loan. Secondly, borrowers are likely to repay loans whilst the
asset value exceeds the total amount of money outstanding on the loan. When
property prices are continuously increasing the bank will perceive that
property lending incurs a very low credit default risk, and will therefore
attribute a very low level of credit default risk when lending for property
purchase. Levels of credit default, and bank provisions for bad and doubtful
debts, are likely to increase substantially in the event of a significant reduction
in property prices.
It is alleged that Barclay’s Bank innovated a further step to the bank credit
creation process, when they offered to provide a third-party with a loan, on
the understanding that the third party purchased newly created shares in
Barclay’s Bank (Financial Times, 2018). The Serious Fraud Office have charged
Barclays Bank with financial assistance as a consequence of this transaction,
because a company is not allowed to loan money for the purpose of
purchasing their own shares. If a bank was allowed to pursue this approach to
raising capital it would remove an important constraint on a bank’s ability to
increase lending. This process caused an account payable liability to be
converted into a customer deposit liability, which then became new Barclays
Bank share capital when the third-party used their loan to purchase new
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Barclay’s share capital (another category of liability on Barclay’s balance sheet)

(Werner, 2014).

The credit creation theory of banking is discussed in more detail within the
electronic mind maps that I have created, which are located on the Economics
Network (Starkey, 2017).

IV. Limitation on Credit Creation:

The commercial banks do not have unlimited power of credit creation. Their
power to create credit is limited by the following factors:
1. Amount of Cash
2. Cash Reserve Ratio
3. Banking Habits of the People
4. Nature of Business Conditions in the Economy
5. Leakages in Credit-Creation
6. Sound Securities
7. Liquidity Preference
8. Monetary Policy of the Central Bank
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V. Limits to credit creation:

The capacity of the bank to create credit is subject to certain limitations which
are given below.
(i). Cash Drain
(ii). Transfer of deposit to non bank financial institution
(iii). Willingness to borrow
(iv). Different types of loan
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Bibliography
Financial Times. (2018, February 12th). Barclays charged a second time over
Qatar cash injection. Retrieved from Financial Times:
https://www.ft.com/content/9eb75568-0fcf-11e8-8cb6-b9ccc4c4dbbb
Macfarlane, L., Ryan-Collins, J., Bjerg, O., Nielsen, R., & McCann, D. (2017,
January). Making Money from Making Money: Seigniorage in the
Modern Economy. Retrieved from New Economics Foundation:
http://neweconomics.org/wp-content/uploads/2017/05/NEF_MAKING-
MONEY-OUT-OF-MONEY_amendment_E.pdf
McLeay, M., Radia, A., & Thomas, R. (2014). Money creation in the modern
economy. Retrieved from Bank of England:
https://www.bankofengland.co.uk/-/media/boe/files/quarterly-
bulletin/2014/money-creation-in-the-modern-
economy.pdf?la=en&hash=9A8788FD44A62D8BB927123544205CE476E
01654
Ryan-Collins, J., Greenham, T., Werner, R., & Jackson, A. (2011). Where Does
Money Come From? A Guide to the UK Monetary and Banking System.
London: New Economics Foundation.
Starkey, M. (2017, September). Interactive mind maps in economics. Retrieved
from The Economics Network:
http://www.economicsnetwork.ac.uk/archive/starkey_mindmaps/
Werner, R. (2014). How do banks create money, and why can other firms not
do the same? An explanation for the coexistence of lending and deposit
taking. International Review of Financial Analysis (36), 71 - 77.

1
Notes and coins in circulation held outside the banking system by the non-bank private sectorcomprise the liabilities of the Bank of
England (bank notes) and government (coins in circulation), but excludes the notes and coins held by the commercial banking system
within their tills and cash machines. Data relating to notes and coins in circulation is acquired from the Bank of England dataset ‘quarterly
amounts outstanding of M4 private sector sterling holdings of notes and coin (in sterling billions) not seasonally adjusted’ [which is dataset
LPQVQKT]. Sterling M4ex(excluding intermediate OFCs (other financial corporations))measures broad money in circulation by presenting
the deposit liabilities of banks and building societies, whilst excluding commercial bank reserves held at the Bank of England. Sterling M4ex
was acquired from Bank of England dataset ‘quarterly amounts outstanding of UK resident monetary financial institutions' sterling M4
liabilities to Private sector excluding intermediate OFCs (in sterling billions) not seasonally adjusted’ [Bank of England dataset RPQB3DQ]
to calculate the total amount of money in circulation for the purpose of calculating the total value of commercial bank credit money
(liabilities of commercial banks). The total value of commercial bank credit moneyis obtained by calculatingthe difference between these
two values.
2
The central bank also influences demand for loans when setting the central bank base rate. A lower interest rate encourages increased
bank borrowing, as a consequence of reducing borrowers cost of bringing forward future consumption. The central bank also influences
demand for bank borrowing by influencing wider economic conditions, as a consequence of the central bank’s monetary policy stance.