Do Banks Create Credit? Answered!

Get the answer of: Do Banks Create Credit?

There have been two views on this subject: one held by certain economists like Hartley Withers, and the other held by practical bankers like Walter Leaf.

According to Withers, banks can create credit by opening a deposit, every time they advance a loan. This is because every time a loan is sanctioned, payment is made through cheques by the customers. All such payments are adjusted through the clearing house. So long as a loan is due, a deposit of that amount remains outstanding in the books of the bank. Thus every loan creates a deposit. But this is an exaggerated and extreme view.

Dr. Leaf and practical bankers do not agree with this view. They go to the opposite extreme. They hold that banks cannot create money out of thin air. They can lend only what they have in cash. Therefore, they cannot and do not create money.

This view is also wrong because it is based on arguments relating to a single bank. As pointed out by Prof Samuelson, “The banking system as a whole can do what each small bank cannot do: it can expand its loans and investments many times the new reserves of cash created for it, even though each small bank is lending out only a fraction of its deposits.”

In fact, a bank is not a cloak room where one can keep currency notes and claim those very notes when one desires. Banks know by experience that all depositors do not withdraw their money simultaneously. Some withdraw while others deposit on the same day. So by keeping small cash in reserve for day-to-day transactions, the bank is able to advance loans on the basis of excess reserves. When the bank advances a loan it opens an account in the name of the customer.

The bank knows by experience that the customer will withdraw money by cheques which will be deposited by his creditors in this bank or some other bank, where they have their accounts. Settlements of all such cheques are made in the clearing house. The same procedure is followed in other banks. The banks are able to create credit or deposits by keeping small cash in reserves and lending the remaining amount.

In granting a loan, a bank actively creates a claim against itself in favour of the borrower. “The claims the bank takes from its customers, in exchange for the deposits entered in the books, are the bank’s assets. The standard assets of a commercial bank are overdrafts and loans, bills discounted, investments and cash.”

The bank provides overdraft facility to a customer on the basis of some security. It enters the amount of the overdraft in the existing account of the customer and allows him to draw cheques for the overdraft amount agreed upon. It thus creates a deposit.

When a bank discounts a bill of exchange, it in fact, buys the bill from the customer for a short period of 90 days or less. The amount of the bill is credited in the account of the customer who withdraws it through a cheque. Or, it pays the sum through a cheque on itself. In both cases, the bank creates a deposit equal to the amount of the bill of exchange less the discount charges.

A commercial bank also creates a deposit by making investments by buying government bonds and securities. The bank pays for the bond through a cheque on itself to the central bank. If it buys a bond from the stock exchange, it credits the amount in the account of the seller, if he happens to be its customer.

Otherwise, it pays a cheque on itself which is deposited in some other bank. In any case, a deposit is created either in this bank or some other bank. In all such cases, liabilities and assets in the banking system on the whole are increased. Thus loans by banks create deposits. It is in this sense that credit is created by commercial banks.