Bank lending by a small commercial bank

It is sometimes alleged that money creation is not possible when the lending bank is a small commercial bank. The bank, it is held, must first find the money before it can lend it out to a borrower. It is a real life issue, and this the way an individual bank will "think" and operate. However, money creation by the banking system still takes place in this case.

The small commercial bank (Bank A) will enter the money market and attract a new deposit [equal to the loan (say, LCC 100 million) it is to provide to Company A] from an institution (assume Retirement Fund Z) by offering an attractive deposit rate. Company A's purpose of borrowing is to purchase goods from Company B. Company B banks with Bank B. Retirement Fund Z banks with Bank Z but is happy to move a deposit if the rate is attractive, as in this example. For the sake of pedagogy we will ignore the RR. Keep in mind that Retirement Fund Z is a member of the NBPS.

Bank A obtains a LCC 100 million deposit from Retirement Fund Z, and Bank Z loses the deposit. Bank A credits Company A's current account127 with LCC 100 million which is spent immediately by making an EFT in favour of Company B at Bank B. Company B dispatches LCC 100 million goods to Company A. The changes to the balance sheets are shown in Balance Sheets 59 - 65. (Retirement Fund Z = RFZ.)

BALANCE SHEET 59: BANK A (LCC MILLIONS)

Liabilities

Loans (Company A)

+100

Deposits of NBPS (RFZ)

+ 100

BALANCE SHEET 60: RETIREMENT FUND Z (LCC MILLIONS)

Assets

Liabilities

Deposits at Bank Z Deposits at Bank A

-100 +100

Total

BALANCE SHEET 61: COMPANY A (LCC MILLIONS)

Goods

+100

Loans (Bank A)

+ 100

Total

+100

BALANCE SHEET 62: COMPANY B (LCC MILLIONS)

Assets

Liabilities

Goods

Deposits at Bank B

-100 +100

Total

BALANCE SHEET 63: BANK B (LCC MILLIONS)

Assets

Liabilities

Reserves at CB

+100

Deposits of NBPS (Co B)

+ 100

Total

Reserves at CB

-100

Deposits of NBPS (RFZ)

-100

Total

-100

BALANCE SHEET 65: CENTRAL BANK (LCC MILLIONS)

Assets

Liabilities

Bank reserves

Bank Z

-100

Bank B

Total

+100

The two banks will find one another in the b2b IBM and Bank B will provide an interbank loan to Bank Z at the interbank rate established between them. As you are now familiar with the interbank market I do not need to spell out the entries to you. The critical question is what happened to the amount of money in circulation? A consolidation of the three banks' balance sheets128 will reveal (see Balance Sheet 66) that M has increased by LCC 100 million and the BSSoC is an increase in bank loans by the same amount. You will know that the real cause is the satisfied demand for loans.

BALANCE SHEET 66: CONSOLIDATED BANKING SECTOR (LCC MILLIONS)

Assets

Liabilities

Loans extended (Co A)

+100

Deposits of NBPS (Co B)

+ 100

+100

Total

+100

What is the lesson? It is a significant one and is that while individual banks "think" they need to get a deposit before they lend, this is not strictly required because the amount loaned has a counterpart in the form of a new deposit which most likely ends up with another bank (in the case of a small bank lending). In the case of a large bank extending a large loan, it is quite likely that the new deposit (= new money) could end up with itself. If not, it will get to balance its books by an interbank loan from the bank that received the new deposit. It will be evident that in the above we assume that these were the only transactions that took place on that particular business day.

Banks are "fully lent"

In conclusion, a refutation is required of the fallacy that banks at times have no more money to lend because they are "fully lent". From the above you will have gauged that this is not so. A perusal of the balance sheet of any bank will indicate that banks are fully lent at all times; their assets (= mainly loans + CBM) are fully matched by their liabilities (mainly deposits + CB loans) and equity. This is the proof. Note that this is usually the case. In exceptional times, as in the time of so-called quantitative easing (QE I and QE II are examples), the banks have ER, but this is engineered by the CB.

You also know that banks are able to create money by simply making loans, i.e. they expand their balance sheets whenever a borrower asks for a loan, provided the project is sound or the individual can service the new debt. This is the business of banking, and banks compete with one another to get this business.

So, money is always available - to be created. Governments want banks to manufacture more money because this underlies new economic growth and increases employment. The trick is to manage creation responsibly, which is the turf of the CB.

 
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