From the Known Money Multiplier through the Banking System to a New Perspective

When an individual or corporate client makes a deposit at a bank, the latter can utilize the value of the deposit at will, but within regulatory limitations imposed by supervisory agencies and designed to ensure that a fraction ([f] in banking parlance, for instance 10% of a $1000 deposit, or $100) is kept available to cover potential withdrawals from the bank's depository. In the instance portrayed, the bank will now be able to utilize the remaining balance of $900 for lending or other activities, in the service of one or more clients.

With a given transactional case, for instance a lending activity, the process will similarly generate a bank deposit – such that a lending operation involving the $900 would only allow $810 to be disbursed for a loan, the remaining $90 being kept in regulatory reserve. By repeating the process, calculations would show that the bank is free to distribute a total of loans in the amount of [1000(1 f/f)] – for our case $1710, while the initial deposit was $1000! In the case example above, with only one loan following the original deposit of $1000, the bank would have placed $190 into discretionary reserves. With the remaining $810, the bank can again grant a new loan of $729, then of $646, etc. If, because of the administrative process, each loan is separated by a two-month time lag per year, at the sixth loan, $6582 will have been distributed including the original $1000 deposit. This phenomenon is called the credit multiplier.[1]

Further comments will be made about the “multiplier”; about the motivation for the banks to distribute credits, and the risks attached besides the first one – the credit risk that they are supposed to be qualified to handle as professionals. For each movement of funds, the bank transforms deposits into loan transactions – a process termed “conversion”. In this manner, banks earn money through the differential effect of the credit rate as applied to internal deposits, and the additional external rate applied when making loans to clients. However, at the same time loans (such as real-estate ones) will have a longer duration than the deposits that usually can be withdrawn at will. The conversion process thus generates a liquidity risk for the bank, explaining the regulatory reserve we have talked about above. Aside from the limited velocity of transactions, this multiplier may have an almost unlimited effect if the bank did not keep some of its funds available as disbursement liquidity, or if the central bank did not implement some limitation measures on the commercial bank to ensure execution of two requirements: (1) that some of the funds be kept available as open liquidity and (2) that some of the funds be delivered back as deposits into banking reserves. Understanding its mechanism, we notice that the multiplier is a reality not limited to banks, but banks on the contrary were an arm to limit its effect as long as only bank financing was the ordinary money stream for the economy and its refinancing. As long as fractional reserves were regulated conditional on the volume of money to be recycled within the system, correctly or not, it was under possible control. Since bank refinancing is no longer the main source of financing for the economy, the multiplier factor can be analysed more generally as the rotation of money, but should encompass all actors keeping books and records and more than tender money. A growing exchange platform linking market participants, producers and consumers, if not the same, is a money issuer to the extent that its balances are accepted; new money has escaped from its traditional frame and limitations that the multiplier had set, either by regulation through banks or by physical means. Only the latter remains, but cannot be looked at in the same way depending on the nature and legal statute of the balances.

  • [1] In 1811 England, in the case Carr vs. Carr, Sir William Grant concluded that if money deposited at the bank was not identified as belonging to the depositor, then it belonged to the bank. In other words, a deposit (gold) is treated as a loan to the bank. Accepted as precedent-driven law in the British legal system and never subsequently challenged, this court decision constitutes the historical basis for lending as a bank function, and for characterizing and regulating the risk taken on public deposits (inclusive limits on liability imposed by central banks or governmental agencies, i.e. the present deposit insurance and restitution liability for European banks is capped at €100,000). In the USA, the deposit insurance has been raised to a $250,000 cap per account. The deposits with US banks have been estimated in September 2013 at $10 billion being insured.
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