What Is Credit Creation?

The
banks whose operations mainly influence the money supply are called
commercial bunks, because in the early days, most bank borrowers were
engaged in commerce rather than manufacturing. These banks perform a
variety of service functions. My bank receives my paycheck every month,
allows me to draw checks on the account, and sends me a statement at the
end of the month. But this is an unexciting and not very profitable
operation. The lifeblood of commercial banking is lending — sizing up
would-be borrowers and advancing them money at a price.

What happens when a bank makes a loan? A company applies for a loan of
$1 million, and the bank agrees. The company gives the bank a piece of
paper promising to repay the loan after, say, six months. The bank gives
the company an addition of $1 million to its checking account. Money
supply increases. When the time for payment comes round, unless the loan
is renewed, repayment is made by deducting $1 million from the
company's checking account. The central principle is simple: Making a
loan creates money, while repaying a loan extinguishes money.

This looks very easy and profitable — the bank just creates money by a
stroke of the pen. So why not create as much money as possible? The
difficulty with this idea is that when people and companies have
checking accounts, they are likely to use them. In addition to writing
checks, they may want to draw out part of their deposit in cash. So a
bank must have some cash in the vault, and a place where it can go for
more cash if necessary. In short, a bank must have reserves.

What, concretely, are reserves? They consist partly of currency (bills
and coins) held in the bank to meet day-to-day requirements. Most
reserves, however, take the form of deposits (checking accounts) with
the Federal Reserve System. All national banks must be members of the
system, and the Fed requires them to carry reserves equal to a specified
percentage of their deposits. In addition, under the Monetary Control
Act of 1980, all banks and savings institutions, whether members or
non-members, must carry a certain percentage of their deposits as
reserves and must report on this regularly to the Fed. This "certain
percentage", the minimum legal reserves-to-demand-deposits ratio, is
usually called the reserve requirement.

If the volume of their demand deposits is already so large that the
banks have just enough reserves to satisfy the reserve requirement, they
can create no demand deposits, for to do so would cause the
reserves-to-demand-deposits ratio to fall below the minimum legal level.
On the other hand, if the banks have more than enough reserves to meet
the reserve requirement, they can expand their loans and investments by
creating additional demand deposits.