AQA Specification focus:
‘How banks create credit.’
Introduction
Banks play a crucial role in the modern economy by expanding the availability of credit. Through their lending and deposit activities, they effectively create money beyond physical currency.
The Concept of Bank Credit Creation
The Basic Idea
Commercial banks are not just intermediaries that pass on savings to borrowers. They create credit by issuing loans, which simultaneously generate new deposits in the banking system. This process increases the total money supply in the economy, even though no new physical cash is printed.
Key Mechanism of Credit Creation
When banks grant loans, the following process occurs:
A borrower receives a loan, usually in the form of a deposit in their bank account.
This loaned deposit is spendable money, which can be used to purchase goods, services, or investments.
When the borrower spends this money, the recipient typically deposits it into another bank, creating a fresh deposit.
The second bank can then use part of that deposit to make new loans, continuing the cycle.
This is why credit creation is often described as a multiplier process: one initial deposit supports a larger increase in the total money supply.
Definitions
Credit Creation: The process by which commercial banks expand the money supply by issuing loans that create new deposits in the banking system.
Deposit Multiplier: The theoretical ratio that shows how much the money supply can increase based on an initial deposit, depending on the reserve ratio.
The Role of Reserves and Regulation
Reserve Requirements
A bank cannot lend out all the money it receives as deposits. It must hold a fraction as reserves. These reserves are either:
Cash reserves (kept to meet withdrawal demands).
Central bank deposits (held to settle interbank transactions).
The reserve requirement directly limits how much credit a bank can create. If the reserve ratio is high, banks must hold more funds, reducing their capacity to lend.
Regulation and Prudence
Modern financial systems impose regulatory standards on liquidity and capital adequacy. These rules restrict excessive credit creation, ensuring that banks remain solvent and stable. Regulations reduce the risk of overexpansion of credit, which can fuel inflation or financial instability.
Interaction with the Central Bank
Central Bank Oversight
While commercial banks create credit, the central bank has ultimate control over the growth of credit and money supply. It can influence credit creation by:
Adjusting the base rate of interest, which affects borrowing demand.
Imposing reserve requirements or capital rules.
Engaging in open market operations, altering the amount of reserves in the system.
Liquidity Support
If banks face shortages of reserves, the central bank may act as the lender of last resort, supplying emergency liquidity to prevent collapse.
Factors Affecting the Extent of Credit Creation
Several factors determine how much credit banks can create in practice:
Public confidence: If depositors trust banks, they are less likely to withdraw cash, allowing banks to lend more.
Demand for loans: Without sufficient demand from creditworthy borrowers, banks cannot expand credit.
Interest rates: Low rates stimulate borrowing, encouraging credit creation.
Capital adequacy: Rules on how much equity banks must hold affect lending capacity.
Economic conditions: In recessions, banks may be more cautious, slowing credit creation.
Credit Creation and the Money Supply
Narrow vs Broad Money
Credit creation mainly expands broad money (which includes bank deposits), not narrow money (which is just cash and central bank reserves). This is because deposits created through lending increase the overall availability of money that households and firms can spend.
Transmission to the Economy
Increased credit fuels aggregate demand (AD) by enabling more consumption and investment. However, if credit expands too rapidly, it can contribute to inflation or asset bubbles.
Risks Linked to Credit Creation
While credit creation is essential for economic growth, it carries risks:
Over-lending: Can lead to unsustainable debt levels.
Bank runs: If too many depositors demand cash simultaneously, banks may fail.
Systemic risk: A banking crisis can spread quickly, undermining the whole financial system.
These risks underline why strong regulation and effective central bank oversight are necessary.
Final Notes on Specification Alignment
The AQA specification requires students to understand how banks create credit. This involves knowing that commercial banks generate new money supply through lending, constrained by reserves, regulations, and central bank policies. Students should also grasp the distinction between the theoretical process of credit creation and the real-world limitations imposed by demand, regulation, and risk.
FAQ
Credit creation goes beyond transferring existing funds. When banks issue loans, they simultaneously create new deposits in the borrower’s account, effectively expanding the money supply.
In contrast, lending out physical cash does not generate additional deposits and therefore does not increase broad money. Credit creation relies on the banking system’s ability to recycle deposits through multiple rounds of lending.
If depositors trust banks, they are less likely to withdraw large amounts of cash. This stability allows banks to lend more of their deposits.
When confidence is low, withdrawals reduce reserves, restricting the bank’s capacity to expand credit. Crises of confidence can therefore sharply reduce credit creation, even if banks remain solvent on paper.
Interbank markets allow banks to borrow reserves from one another to meet short-term obligations.
This system supports credit creation because:
Banks can lend more, knowing they can cover reserve shortages through interbank borrowing.
Liquidity is smoothed across the system, reducing constraints on credit growth.
However, when interbank markets freeze, as in financial crises, credit creation can collapse.
Credit creation impacts sectors unevenly.
Households: Access to mortgages and consumer loans expands spending capacity.
Firms: Investment is financed by loans, supporting business growth.
Government: Indirectly benefits as higher spending can boost tax revenues.
If credit disproportionately flows to housing or financial assets, other productive sectors may be underfunded, leading to imbalances.
Yes, during periods of deleveraging, banks may reduce lending, causing deposits to shrink.
This can occur when:
Banks tighten lending standards.
Borrowers repay more than they borrow.
Confidence in financial stability declines.
Negative credit creation reduces broad money, potentially leading to lower aggregate demand and deflationary pressures.
Practice Questions
Define the term credit creation in the context of commercial banking. (2 marks)
1 mark for recognising that commercial banks create money/credit.
1 mark for stating that this happens when loans generate new deposits in the banking system.
Explain how commercial banks create credit and outline two factors that limit the extent of credit creation in practice. (6 marks)
Up to 2 marks for explaining that when banks lend, new deposits are created which expand the money supply.
1 mark for reference to the reserve requirement or liquidity/capital adequacy rules as a limiting factor.
1 mark for mentioning central bank regulation or control of interest rates as a limiting factor.
1 mark for recognising the role of demand for loans or public confidence in limiting credit creation.
1 mark for overall clarity and coherence in linking the process of lending to constraints on credit creation.
