How Do Commercial Banks Create Money?

Banks are profit-making private businesses, just like retail stores and supermarkets. Some banks are quite small, with just a few branches, and they do business in a limited area. Others are among the largest corporation, with hundreds of branches spread across many states. The key role that banks play in the economy is to accept deposits and make loans. By doing this, they create money.   What constitutes money, anyway? In the narrowest sense, money refers to all the cash and coins that are in circulation. But it also includes the value of traveler’s checks, the value of checking account balances, saving account balances, certificates of deposits (CDs), balances in money market deposit accounts, plus all non-institutional money market fund shares.  

Paper money (cash) accounts for less than 3 percent of the total stock of money in many advanced economies. All other forms make up the remaining 97 percent of the money supply, and most of these are deposits in commercial banks. This, however, doesn’t mean that all this money are physically kept within the banks, as vault cash, or on deposit with the Reserve Bank. Commercial banks are required by law in most countries to keep around 10 percent of their checking account deposits as reserves above the threshold level. These reserves are called “Required Reserves” (RR). Indeed, banks must always keep at least the required reserve ratio to guard against the possibility that many depositors may simultaneously make withdrawals from their accounts. But in reality, individuals and business firms normally keep the amount of currency they hold constant relative to the value of checking account balances. So, we would expect to see people increasing the amount of currency they hold as balances in their checking accounts.   Deposits are liabilities to banks because they are owed to individuals and business firms that have deposited the funds. If you, for example, deposit Rs.1000 into your checking account, the bank owes you Rs.1000 and you can ask for it back at any time. Besides, banks don’t earn interest on the “Required Reserves.” For all these reasons, banks must make use of all their excess reserves (90%) to create money.   Banks can lend out many times more than the amount of cash and reserves they hold. When commercial banks make loans, they increase checking account balances, and the money supply expands. That is, commercial banks can create new money through the accounting they use when they make loans. While this is often hard to believe at first, it’s common knowledge to the people who manage the banking system. In March 2014, the Bank of England released a report called “Money Creation in the Modern Economy”, stating: “Commercial (i.e. high-street) banks create money, in the form of bank deposits, by making new loans. When a bank makes a loan, for example, to someone taking out a mortgage to buy a house, it does not typically do so by giving them thousands of pounds worth of banknotes. Instead, it credits their bank account with a bank deposit of the size of the mortgage. At that moment, new money is created.” In other words, new money is created by commercial banks when they extend or create credit, either through making loans or buying existing assets. In creating credit, banks simultaneously create deposits in our bank accounts, which, to all intents and purposes, is money.   The flip-side to this creation of money is that with every new loan comes a new debt--- not borrowing from someone else’s deposits, but money that was created out of nothing by banks. Eventually the debt burden can become too heavy, resulting in the wave of defaults that trigger a financial crisis, as in the case of the housing financial crisis in 2008 in the United States.   The primary determinant of how much banks lend is not interest rates, but the confidence that the loan will be repaid and the confidence in the liquidity of the mortgage assets and/or the collateral against the loan amount.   More specifically, here are some of the ways commercial banksmake money:   First, they make money by providing loans and earning interest income from those loans. When customers deposit money, such as checking accounts, savings accounts, money market accounts and certificates of deposits (CDs), they earn interest on these deposits from the banks. However, the interest rate paid by the banks on money they (the banks) have raised is less than the rate charged on money they lend. Or, commercial banks may borrow money from larger banks at a preferred interest rate to fund loans. This is how they make money from the loan itself. For example, suppose a customer purchases a five-year CD for Rs.100,000 from a commercial bank at an annual interest rate of 3%. On the same day, another customer receives a five-year auto loan for Rs.100,000 from the same bank at an annual interest rate of 7%. Assuming simple interest, the bank pays the CD customer Rs.15,000 over five years, while it collects Rs.35,000 from the auto loan customer. The Rs.20,000 difference is an example of spread – or net interest income – and it represents revenue for the bank.   Second, commercial banks make money from mortgage loans. For example, when you buy a home by taking out a loan from a bank, that bank would start charging you several fees, such as a loan origination fee, application fee, underwriting fee, processing fee, etc.In addition, the bank that owns your loan would collect interest charges for the first 10 to 20 years for a 30-year, fixed-rate loan. And often, the total amount on interest due on a 30-year, fixed-rate loan could exceed the original amount of the loan taken. This interest is the profit a bank earns for lending you the money to buy a home.   Third, commercial banks make money from credit cards. Certainly not all banks do credit card lending, but those that do make a lot of money. For example, some issuers of credit cards may charge annual fees on their clients. Of course, annual fee amounts vary wildly depending on the card, but they can run into the hundreds of thousands of Rupees for some premium plastic. There are penalty fees for overdrafts and for late payments on bank-issued credit cards. These fees, and more, can add up to a large part of the average annual profit for the commercial banks that issue credit cards.   When it comes to the current banking system in Nagaland, our Nagasbasically depend on the State Bank of India and other commercial banks which are designed with Indian people in mind. While these banks certainly provide some services to us, sometimes they seem hesitant, if not reluctant, to provide loans to the public because our houses and landed properties cannot be used as collaterals against their bank loans.Unfortunately, this problem cannot be easily resolvedsince our Nagas have a unique land-holding system. Because of this reason, we Nagas may do well to develop our own banking system. And yes, those who get into the banking business can make a lot of money as well.