Paying depositors 3% for their money, lending it out at 6% interest to borrowers then heading out to the golf course by 3 pm (3-6-3).

This was once used to describe how bank’s business model works. Banks function as an intermediary between depositors and borrowers, allowing the financial institution to earn a spread between the funding cost and lending rate. The process of borrowing depositors’ money (short-term funding) and lending out credit (long-term loans) give rise to money creation in an economy. How does this actually work then?

Money Supply and the Multiplier Effect

The expansion of the money supply in an economy is driven by a multiplier effect which depends on the % of deposits banks are required to hold as part of their reserves (these reserves are deposited with the central bank). A simple example can be illustrated below.

Assuming that the central bank requires all banks to hold 20% of deposits as reserves (i.e. a required reserve ratio of 20%). Suppose Banks A and B (as shown in Figure 1 below) are already in operation with current loans of \$100 and \$80 in their books respectively. At all times, both banks must maintain at least 20% of total deposits as reserves. Bank A currently has 50% of its deposits held as reserves while Bank B has a 60% reserve-to-deposit ratio. Bank deposits are basically a record of how much they owe to customers, hence a liability.

*Reserves are deposits held by the central bank and can be transferred in between banks

Let’s say Person PENNILESS wants to buy a watch. PENNILESS decides to take on a \$60 loan from Bank A to make the purchase. Bank A creates a new loan of \$60 in its books while adding \$60 into PENNILESS’s deposit account in Bank B (on the ATM screen, PENNILESS’s account reflects an additional \$60) as shown in Figure 2 below. At this moment, new money is created.

As both assets and liabilities need to match, Bank A has to transfer its proportionate share of reserves to Bank B in order to settle the transaction. This process of credit lending has resulted in the creation of \$60 in the economy as shown in Figure 3 below.

Such transactions can continue as long banks meet their mandated reserve requirements. If a bank continues to create new loans, it will eventually use up its reserves as deposits get withdrawn or transferred. Hence, in order to continue lending, banks must attract additional deposits to maintain/increase their reserves.

#### Value Recap!

Banks intermediate the transfer of money between depositors and borrowers, creating money during the process. The creation of loans is limited by the amount of reserves a bank is required to hold (i.e. a reserve requirement ratio as mandated by the central bank).