We all do have deposit or saving account at the bank, and we can withdraw as and when we require funds, but in general not everybody would be asking for money at the same time. When a person A is withdrawing money from ATM, a person B might be depositing cash in his account, in short if a bank is holding 100 units of depositors money on day 1, in all likelihood it would be holding 95 -105 dollars on day 2. Which means if the bank keeps 5 Dollars aside, it can loan the spare 95 dollars to a credible borrower and earn some money as interest. Warehouse which host our goods are in a way similar to the banks in guaranteeing the safety of our goods just as the bank do guarantee our money, but while warehouse charge us for safekeeping, banks pay us for maintaining our deposits at bank. The concept of Bank lending depositor’s money, while keeping a fraction of it is called Fractional Reserve banking.
Fractional Reserve Banking and Money Creation
Client A1 of Bank A just received a cheque worth 1000 units of currency; he deposits the cheque in his account at Bank A.
Now Bank A has 1000 units of currency in its kitty to loan its clients (for the time being forget all the other funds its holding in the accounts of its clients), if the reserve requirement is 10% Bank A has to keep 100 units of currency aside and can loan the remaining 900 units of currency.
Client A2 of Bank A applies for a loan, A2 wishes to purchase an asset worth 1000 units from B1, Client of Bank B. A2 is summoned by Bank A and asked to deposit 100 units of currency as an initial capital while the bank would lend the remaining 900 units. A2 obliges, and the Bank draws a cheque worth 1000 units, drawn on itself payable to Client B of Bank B.
Now Bank A is holding 100 units of currency in cash, it owes Client A1 1000 units while it is to receive 900 units of currency from Client A2 (excluding interest), if Client A2 defaults it can sell the mortgaged asset.
Client B1 of Bank B who has received this cheque deposits it in his account at Bank B, Bank now has 1000 units of currency against which no loan has been issued till date, keeping side 10% it can lend the remaining 900 units. Bank B accepts the loan proposal of Client B2, the Bank asks the client to deposit 10% of the asset value to be financed while it would loan the 90%. Since the asset value stands at 1000 units of currency, after receiving 100 units Bank issues client B2 a cheque worth 1000 units.
Now Bank B is holding 100 units in cash, the bank is liable to pay 1000 units of currency to Client B1 while client B2 owes 900 units to the Bank. In case of default the Bank can recover the lien amount by auctioning the lien asset.
Client A3 of Bank A receives the cheque from B2 and deposits in his Bank, now the Bank holds 100 + 1000 i.e 1100 units of currency against which it has not created any loan, and it can loan 90% of it while it has to maintain 10% as reserves. Bank believes that Client A4 is creditworthy and clears his loan proposal for financing the purchase of asset valued at 1000 to be purchased from Client B3 of Bank B, the Bank loans him 900 units while the client himself adds 100 units.
Bank A can now fulfill cash requirements upto 200 units, Client A1 and A3 both are assured that there funds are safe with the Bank, there total claim on Bank is 2000 units, they both can individually issue cheques worth 1000 units or can swap there cards to finance purchase upto 1000 units. The bank has a claim of 900 units of currency on its two other clients A2 and A4
Client B3 rushes to his bank and deposits the Cheque, Bank B is now enriched by 1000 units of deposits in its account against which no loan has being issued, Bank sanctions the loan proposal of Client B4, the client deposits 10% of the asset valued at 1000 units, Bank issues the Client Cheque payable to Client A5 of Bank A.
Bank B now has a cash holding of 200 units, Client B1 and B3 both are confident of the safety of there funds to the tune of 1000 units withheld in there bank accounts. The Bank itself has a claim of 900 units on its other two clients B2 and B4.
Client A5 deposits the cheque in his bank account, now the bank as 1200 units of currency as deposits of its account holders on which no loan has been made. The Cash received by Bank A as deposits was just 1000 units, but now total money in the Market is 5000 units of currency
1000 Client A1
1000 Client A3
1000 Client A5
200 Bank A Cash holding
1000 Client B1
1000 Client B3
200 Bank B Cash holding
Total 5400 units of Currency
100 Client A2
100 Client A4
100 Client B2
100 Client B4
Total 400 units of currency
So the Bank A along with Bank B has now created 5000 more units of electronic currency, The banks can create infinite amount of currency as long as some asset is kept lien to finance the loan and the receiver of the loan is holding some funds which he can use as down payment for financing the asset. If the Bank finances 100% of the asset then the maximum amount of newly currency would depend on the reserve requirement. If the reserve requirement is 10%, the Banks can create 10 times the initial money supply, if it is 5% then 20 times the initial money supply could be created.
Working
Client A1 issues a cheque worth 300 units of currency to Client B2 of Bank B, If Client B1 of Bank B at the same time issues a cheque worth 300 units of Currency, the two cheques cancel each other. Payment Cheques received by Clients A2 and A4 of Bank and B2 and B4 of Bank B be cancelled to the extent of there EMI’s. If Bank A doesn’t have enough funds to meet its requirement it can borrow funds from other banks or the central bank which is the lender of last resort.
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