Money & Banking

Money & Banking – Commercial Banks Ability To Create Credit

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Key Learning Outcomes


  • Understand how banks create credit/money
  • Understand how a bank reconciles its desire for profitability with its need for liquidity
  • Economic effects and benefits of falling interest rates
  • Effects of Quantitative Easing
  • Why commercial banks should be regulated in Ireland

Introduction: Commercial Banks Ability to Create Credit


The Commercial Banks can create credit by giving out loans. They are able to do this because other people deposit cash with them. The banks can give out loans to a multiple of the cash deposited with them. By creating credit the banks are increasing the supply of money in the economy. Example: Suppose Mr Keane lodges €10,000 in the bank:

Balance Sheet of Bank (Initial position)
Assets Liabilities
Cash 10,000 Deposits 10,000
Total Assets 10,000 Total Liabilities 10,000

The Minimum Reserve Ratio is the amount of money, with respect to short-term deposits, that the European Central Bank (ECB) requires commercial banks to keep in cash form.

We are assuming the ratio is 10% in the following example. With this €10,000 the bank has enough cash to support deposits of €100,000.

It does this by giving out loans to a total value of €90,000. We will assume that the bank gave a loan of €10,000 to nine people. The bank knows that only 10% of total deposits are demanded in cash by customers.

Balance Sheet of Bank (New position)
Assets Liabilities
Cash lodged 10,000 Deposits (Mr Keane) 10,000
Loans given 90,000 New Deposits 90,000
Total Assets 100,000 Total Liabilities 100,000

Increase in Credit = Increase in Cash Deposits x 1/Bank Reserve ratio

As you can see from the above example, the more people who borrow from the bank, the more credit it creates. If the reserve ratio was reduced to 5% of deposits, it could create even more credit. On the other hand, if the bank was required to retain 15% of all deposits its ability to create credit would be constrained. The ECB could specify that this Minimum Reserve Ratio  is 5%, 10%, 15% etc.

Limits on the power of Banks to create credit:

  1. Availability of creditworthy customers
  2. Banking ratios
  3. European Central Bank guidelines
  4. Availability of cash deposits
  5. Demand for loans by customers

Sample Exam Q&A


Question

(A) “Banks may fail by over-extending their loan book”
Explain this statement within the context of a bank’s twin requirement of liquidity and profitability.
(25 Marks)

Sample Answer A

A bank has twin requirements:

Profitability: refers to the need for a bank to make as much profits as possible from its assets to satisfy shareholders within banking rules and regulations. It is generally accepted that the more profitable the asset is the less liquid it is.

 Liquidity: refers to the need by a bank to have liquid assets in order to meet the demand for cash by its customers. It is generally accepted that the more liquid the asset is the less profitable it is.

Banks must strike a balance between the twin requirements of profitability and liquidity. As a result, banks structure their holding of assets along the following lines: banking_credit_01 By focusing on profitability (extending credit) at the expense of liquidity, a bank may give loans to high risk ventures e.g. commercial property development loans. Property loans are highly illiquid but can be very profitable. A bank may run the risk of increasing bad debts, falling share prices, a lack of capital and possible bank failure. By ignoring liquidity requirements, banks may not have enough cash to meet the demand of their depositors and this could result in a ‘run’ on the banks and result in bank failure.

(B) Some central banks have responded to the global financial crisis by introducing the monetary policy measure of “Quantitative Easing” ( i.e. buying financial assets from financial institutions using new money it has created).
(i) Outline two possible economic effects of this measure for an economy.
(4 marks)

Sample Answer B (i)

1 Increased Bank Lending
With increased cash reserves the commercial banks may increase their lending.
2 Economic Growth / Jobs
Increased lending by banks should increase both consumer spending and investment spending which will boost aggregate demand and help create jobs.
3 Possible Inflation
If the money supply increases at a faster rate than the supply of goods and services, then inflation may increase.
4 Interest Rates
An increase in the money supply, after the creation of new money which has been used to purchase financial assets, may lead to a reduction in interest rates. This may restore business confidence and help stimulate economic activity.
5 Government Bonds
If government bonds are purchased, then this may cause their market price to rise, leading to a decrease in their yield.
(B) The European Central Bank (ECB) reduced interest rates in 2014.
(ii) Discuss two possible economic benefits of falling interest rates for the Irish economy.
(6 marks)

Sample Answer B (ii)

1 Borrowing Encouraged
Borrowing is now cheaper, resulting in cheaper loan repayments. This will increase spending power, resulting in a higher standard of living.
2 Savings Discouraged
With a lower rate of inflation people may find it less attractive to save and so they will increase their spending.
3 Reduced Mortgage Repayments
The cost of monthly repayments (on tracker mortgages) decreases resulting in increased disposable income and a higher standard of living.
4 Cost of Servicing the National Debt
With lower domestic interest rates, the cost of repaying the interest portion of the National Debt falls.
5 Costs of Production / Increased Competitiveness
Costs of production will decrease resulting in lower domestic prices. This will increase the competitiveness of Irish exports and may lead to an increase in sales.
6 Incentive to Invest
The Marginal Efficiency of Capital (MEC) will rise resulting in increased profits and this may encourage investors. It becomes less expensive for businesses to borrow and so they may invest.
7 Economic Growth encouraged
With possible increased investment/increased consumer spending, future economic growth in Ireland may be encouraged.
8 Taxation Revenues
With a possible reduction in savings, the government may receive less revenue through DIRT. However, with possible increased spending, the revenue from VAT and excise duties may rise. If unemployment decreases, there will be an increase in income tax revenue, as well as a decline in social welfare payments.
9 Employment
Increased consumer spending; rising demand for Irish exports; an increase in investment and an increase in economic growth may result in an increase in the numbers employed.
(C) Many believe that a lack of supervision (“light–touch regulation”) of financial institutions in Ireland contributed significantly to the banking crises.
Discuss the economic reasons why commercial banks in Ireland should be regulated.
(30 marks)

Sample Answer C

1 Protect Consumers
Regulation will ensure that the interests of  bank customers are protected and that savers’ deposits are secure.
2 Proper Lending Policies
Regulation will ensure that the banks follow correct lending procedures and that excessive/reckless lending is avoided.
3 Banking System Stability
Regulation will ensure that the banking system should remain stable.
4 Economic Stability / Confidence
Proper regulation may ensure that the banks operate efficiently, resulting in public confidence in the banking system/allowing for the flow of credit and for economic growth of the economy.
5 Less need for Government Intervention
If the banks are properly regulated then there will be less need for the government to become involved as it has had to do with the guarantees for savers’ deposits, nationalisation of Anglo Irish Bank, and the setting up of the National Asset Management Agency (NAMA).
6 Less Need for EU/ IMF funds
If banks are properly regulated, it should result in the government not having to resort to funds from the EU/IMF/ECB (Troika) to capitalise the banks as well as having  to stabilise the public finances because the yields on Irish bonds had risen to unsustainable levels, curtailing the State’s ability to borrow.

Student Activity


Q1 The reserve ratio can be defined as:
Q2 Demonstrate how financial institutions can create credit.
Q3 Discuss the limitations on an institutions ability to create credit.
Q4 A banks profitable earning assets are:
Q5 A banks liquid assets are:
Q6 Examine how a bank reconciles liquidity with profitability.
Q7 Analyse the need for regulation of the financial sector.
Q8 State the rate of inflation in Ireland in 2015 as measured by the Consumer Price Index.