How banks create credit - MoneyWeek Investment Tutorials

Summary

This video offers a beginner's guide to credit creation and fractional reserve banking, explaining how banks can generate credit from a small deposit base using a retention ratio. It illustrates the concept with a hypothetical island scenario, where a bank lends out most of a deposited sum while retaining a fraction for liquidity. The script also touches on the importance of confidence in banking systems and the role of central banks in influencing the money supply through mechanisms like the discount rate, reserve requirements, and open market operations, all of which can impact inflation and interest rates.

Takeaways

• 🏦 The script discusses the concept of credit creation and how banks generate credit through the process of fractional reserve banking.
• 📚 Credit creation is a complex topic that can be the subject of an entire degree course, involving various economic principles and terminologies.
• 💡 The script uses a hypothetical island scenario to illustrate the basics of how banks create credit and the role of the money multiplier.
• 💰 The process begins with a deposit, which the bank partially retains and partially lends out, creating an IOU that can be used for transactions.
• 🔄 The bank repeats this process with the loan repayments, retaining a percentage and lending out the rest, effectively multiplying the original deposit.
• 📉 The bank's retention ratio determines how much credit can be created from the original deposit; a lower ratio allows for more credit creation.
• 📈 The formula for calculating the total credit creation is the original deposit amount divided by the retention ratio (1 / R).
• 🤔 The fractional reserve banking system relies heavily on confidence; a bank run, where everyone demands their money back at once, could cause problems.
• 🌐 Different definitions of money supply exist, ranging from M0 (narrowest definition) to M4 (broadest definition), reflecting the concept of potential spending power.
• 🏛 Central banks play a crucial role in influencing the money supply and, by extension, inflation, by setting policies that affect banks' operations.
• 🛠️ Central banks use tools such as the discount rate, reserve requirement, and open market operations to manage the economy's money supply and interest rates.

Q & A

What is the main topic of the video script?

The main topic of the video script is the concept of credit creation by banks and how it relates to fractional reserve banking and the money multiplier effect.

What is the purpose of the hypothetical island scenario in the script?

The hypothetical island scenario serves as an illustrative example to simplify the complex concept of how banks create credit and the role of the money multiplier in the banking system.

What is the role of the bank in the island scenario?

In the island scenario, the bank's role is to accept deposits, hold a fraction of those deposits as reserves, and lend out the remaining amount to customers, thereby creating credit.

What is the term used to describe the percentage of deposits that a bank keeps on reserve?

The term used to describe the percentage of deposits that a bank keeps on reserve is the 'retention rate' or 'reserve ratio'.

How does the bank create credit in the island scenario?

The bank creates credit by lending out a portion of the deposited money to customers, which they can then use for transactions, effectively multiplying the original deposit into more money in circulation.

What is the money multiplier effect?

The money multiplier effect is the process by which a bank can create more money (credit) from a given amount of deposits, based on the reserve ratio it maintains.

What is the formula that economists use to calculate the total credit creation potential from a deposit?

The formula used by economists to calculate the total credit creation potential is 1 divided by the reserve ratio (R), multiplied by the initial deposit amount.

What is the significance of confidence in the fractional reserve banking system?

Confidence is crucial in the fractional reserve banking system because it relies on the assumption that not all depositors will withdraw their money at once, which would otherwise cause a bank run and potentially lead to bankruptcy.

What are the different definitions of money supply mentioned in the script?

The script mentions that there are different definitions of money supply, ranging from M0 (narrowest definition, including only physical currency) to M4 (broadest definition, including various types of near money and potential purchasing power).

What are the three main tools a central bank can use to influence the money supply?

The three main tools a central bank can use to influence the money supply are the discount rate, the reserve requirement (or reserve ratio), and open market operations (buying and selling government bonds).

How do open market operations affect the money supply and interest rates?

Open market operations affect the money supply by either increasing or decreasing the amount of money in the banking system. When a central bank sells bonds, it withdraws money from the system, potentially raising interest rates. Conversely, when it buys bonds, it injects money into the system, which can lower interest rates.

Outlines

00:00

🏦 Introduction to Bank Credit Creation

This paragraph introduces the complex topic of bank credit creation, which is fundamental to understanding the economy. It simplifies the concept by explaining it through a hypothetical scenario of being stranded on an island with a bank. The script discusses the basics of how banks operate with deposits and loans, and the concept of the money multiplier, which is central to the process of credit creation. It also touches on the different definitions of money supply and the importance of the retention rate set by banks for lending purposes.

05:01

📊 The Mechanics of Fractional Reserve Banking

This paragraph delves deeper into the mechanics of fractional reserve banking, illustrating how a bank can lend out a portion of the deposits it receives while retaining a fraction for liquidity. It uses the example of a 10% retention rate to explain how the bank can theoretically create a thousand pounds from an original deposit of one hundred pounds. The paragraph also introduces the formula for calculating the potential credit creation and discusses the importance of confidence in the banking system to prevent bank runs.

10:01

🌐 Central Banks' Role in Monetary Policy

The final paragraph discusses the role of central banks in influencing the money supply and, by extension, the economy. It outlines three main tools that central banks use: the discount rate, the reserve requirement, and open market operations. The paragraph explains how these tools can affect the amount of money in circulation and, consequently, interest rates and inflation. It emphasizes the importance of the central bank's role in maintaining economic stability through careful management of the money supply.

Keywords

💡Credit Creation

Credit creation refers to the process by which banks lend out more money than they hold in reserves, effectively expanding the money supply. In the video's narrative, it is exemplified by the bank lending out 90 pounds of a 100-pound deposit, thus creating credit. This concept is central to the video's theme of explaining how banks can generate funds and influence the economy.

💡Money Multiplier

The money multiplier is a financial term that describes the factor by which a bank or the banking system can create money from a given amount of reserves. In the script, it is used to illustrate how much credit a bank can theoretically create from an initial deposit, such as turning 100 pounds into a thousand pounds with a 10% reserve ratio.

💡Fractional Reserve Banking

Fractional reserve banking is a system where banks only hold a fraction of customer deposits as reserves and lend out the rest. The script explains this concept through the story of an island bank that keeps 10% of deposits and lends out the rest, demonstrating how banks operate with a fraction of the total deposits.

💡Deposit Rate

The deposit rate is the interest rate paid by a bank to those who deposit money. While not explicitly defined in the script, the concept is implied when discussing the bank's decision to keep a certain percentage of deposits (e.g., 10%) to cover potential withdrawals, which is a part of the bank's liquidity management.

💡Money Supply

The money supply refers to the total amount of money available in an economy at a particular point in time. The video discusses different definitions of money supply, such as M0 to M4, and how the bank's actions can affect the total money supply, including the potential inflationary effects.

💡Inflation

Inflation is the rate at which the general level of prices for goods and services is rising, and subsequently, purchasing power is falling. The script connects the concept of inflation to the money supply, explaining that an increase in money supply can lead to higher prices for goods and services.

💡Central Bank

A central bank is the main financial authority of a country, responsible for monetary policy and regulation of the country's financial system. In the video, the central bank's role is discussed in terms of influencing the money supply and setting reserve requirements for banks.

💡Discount Rate

The discount rate is the interest rate charged by a central bank to commercial banks for borrowing reserves. The script mentions this as one of the tools a central bank can use to influence the money supply, though it notes that it's a less commonly used tool.

💡Reserve Requirement

A reserve requirement is the amount of funds that commercial banks must hold in reserve against deposits. The script uses the example of changing the reserve requirement from 10% to 20% to illustrate how this can affect the amount of credit a bank can create.

💡Open Market Operations

Open market operations are the buying and selling of government securities in the open market by a central bank to influence the money supply and interest rates. The script explains this as the most commonly used tool by central banks, where selling government bonds can reduce the money supply, and buying them can increase it.

💡Interest Rates

Interest rates are the cost of borrowing money and the return on investment. The script discusses how changes in the money supply can affect interest rates, with an increase in supply potentially leading to lower rates and a decrease leading to higher rates.

Highlights

The video provides a beginner's guide to credit creation in banking.

Explains the concept of the money multiplier and its role in banking.

Introduces fractional reserve banking and how it works.

Uses a hypothetical island scenario to illustrate credit creation.

Describes the process of depositing money in a bank and the bank's decision to lend out a portion of it.

Explains how banks can create IOUs through lending, effectively expanding the money supply.

Details the importance of the reserve ratio in determining the amount of credit a bank can create.

Presents the formula for calculating the total credit creation based on the reserve ratio.

Discusses the reliance of the banking system on confidence and the risks of a bank run.

Differentiates between various definitions of money supply, from M0 to M4.

Explains the impact of the money supply on inflation and economic stability.

Outlines the role of central banks in influencing the money supply and economic policy.

Describes three main tools used by central banks to influence the economy: the discount rate, reserve ratio, and open market operations.

Explains how the discount rate can influence the attractiveness of financial instruments.

Discusses the effects of changing the reserve ratio on the banking system and money supply.

Details the process and impact of open market operations on the economy.

Concludes with a summary of how central banks use these tools to manage inflation and stabilize the economy.

Transcripts

[Music]

this video is going to take on a little

bit of an economics you type topic very

topical at the moment how do banks

create credit now this is one of those

topics that can take up an entire degree

course there are professors and Nobel

Prize winners out there grappling with

it so don't expect too much rocket

science from this video this is a

beginner's guide to how credit creation

works and I'll be throwing in a couple

of other bits of jargon that are

popularly associated with it what is the

money multiplier there we're going to

Taylor at the moment and how does

fractional reserve banking work okay so

all of that in a one video but

essentially it boils down to this what

is credit creation and more importantly

when people talk about the money you

supply what do they mean is it possible

to have more than one definition of the

money supply and the answer is yes it is

and I'll try and explain why that is in

just a moment now then a hypothetical

scenario allow me a bit of artistic

license here okay imagine this

is an island okay surrounded by

shark-infested water shark right another

shark all right so it's an island and

you are washed ashore on this island now

bear with me there is a point for this

all right with a hundred pounds admits

fairly unlikely scenario so far but bear

with me so as far as you know that is

you on the island and you've washed

ashore hundred pounds

all right somehow that survived the

vacuole just been in the sea right and

you're thinking right well I I need 100

pounds I don't know anything about this

island it could be full of wild animals

or cannibals running so when I wander

around and see if I can find myself

something to spend 100 pounds on and

blow you down if the first thing you

don't find on the island isn't always

the way is a bank okay so you think

right what about hundred pound just

washed up all the bring the island so

maybe what I better do is is put this

money somewhere safe for the time being

all right so you find a bank and you

think right I want to do I'll go in and

I'll put the money on deposit for the

bank all right look is until I can find

something spending on it's probably

safer in there all right so you put your

hundred pounds into the bank all right

so that there it goes now then you sort

of wander off try not to get eaten

right now the bank makes a quick

calculation okay it thinks right

if Kim comes back in in half an hour's

time how much of that hundred pounds do

I need to keep back now you might see a

hundred pounds but actually that's

unlikely when you go to the cash point

machine you don't generally drain the

entire account okay you take 50 pounds

out or ten pounds or something right so

the bank is going to be thinking I need

to hold some of this hundred pounds

ballade I don't necessarily need you to

settle more one hundred pounds just in

case

Tim happens to want some out of the cash

point machine tomorrow morning or comes

back in and asked to redraw it so maybe

what I'll do is I'll hold back on ten

pounds

okay and I'll lend out the remaining 90

now the bank has a customer who wants to

borrow money so the bank keeps ten

pounds back and lends out ninety to that

customer all right and the reason that

customer wants the money is they want to

trade all right they want to buy

something with it so if you're following

me now the 90 the 90 pounds in the form

of the IOU if you like the customer

wants to buy some goods all right and so

basically they do a trade and this

person who they've just traded with then

decides to put the 90 pounds for

safekeeping

back into the bank and the bank thinks

okay I better hold 10% of that back in

case this customer comes back looking

for money tomorrow morning so the bank

keeps nine pounds and then all ends out

81 now I'm running a have Island here

you probably get the idea with a 10%

deposit rate if you like or retention

rate the bank can keep creating io u--'s

that allow other customers to undertake

transactions or to trade okay so the

bank is estimating that it can get away

with only holding back 10% of each

deposit it doesn't need to hold the

whole lot and actually if you carried on

this process with more and more

customers I'll stop after sort of the

first three if you like you could work

out in theory how many io u--'s or how

much credit the bank could create of one

deposit of 100 pounds all right and the

answer actually on a 10% retention ratio

is in total deposit terms the bank could

create effectively a thousand pounds out

of 100 all right

if I change this to the bank keeping 20

pounds back of the original 100 pounds

all right then the bank would only be

able to create 500 pounds in total all

right

made up the deposits and credit so in

other words the rate that the bank

decides to use to determine what

proportion of say the hundred pound

deposit it's going to keep and what

proportion is going to lend out

determines in turn how much credit in

total could be created from the original

100 pound deposit all right there's a

little formula that economists use which

I want for you with too much but one

over R where R is armed the rate and so

for example if R is 10% all right then

100 pounds divided by 10% which is not

0.1 is a thousand okay if the the rate

is 20 percent 100 pounds over point two

that's 20 percent is 500 pounds and so

on so I'm being a little bit fast and

loose with my economic jargon here but

that's that's by the by the principle is

that this system allows the bank to

generate if you like credit generate

funds from a relatively small deposit

base all right then that's the essential

basis of what's called fractional

reserve banking now you might be

thinking there's a problem with this and

there is a big one it relies on

confidence it relies on the bank judging

or perhaps being told by a central bank

that 10 percent is the right ratio for

example because it does rely on people

not literally running map the bank and

demanding all their money back at once

that would cause me the problem and all

the banking system is built on that

basis I'm not expected to go running

down to Lloyds TSB this morning and

empty all my accounts in one go I mean

in theory I'm entitled to do exactly

that

the banking works on the premise that I

won't because my day-to-day existence

doesn't require me to have access in

cash terms to all the money that in

theory belongs to me

right so obviously getting that ratio

right is fairly important and what we'll

do is just wrap up by considering in

essence how central bank's influence the

supply of money in an economy because

economists will look at this island and

say how much money is on the island it

depends what you mean by money you see

some people would say well there's only

ever a hundred pounds here somewhere

isn't there you know that's what I

washed ashore with or maybe not maybe as

soon as the bank enters a transaction

with whoever this is is the money supply

could you widen the definition and say

the money supply is more like those two

adil together if you know the money

supply is sort of potential spending

power let's say so you get these

different definitions of the money

supply they call Em's m naught all the

way through to m4 and without going into

the detail economics of it they're based

on the idea that money is a slightly

fluid concept is it just notes and coins

in circulation or is there a bit more to

spending power than that okay now maybe

a final note in this video on central

banks and their role in this sort of

whole arena because there is there a

couple of questions thrown up here and I

won't attempt to answer them in detail

but one of them is you know what

determines whether that's 100 pounds or

not in the real world rather than this

des Island where I was washed up and the

out the money supply is something that

has a direct bearing on inflation the

more money in an economy and the fewer

goods and services there are are they

able to buy the further the price of

those goods and services to be pushed up

okay so you know if I put a central bank

in here somewhere

governing all activity in financial

terms on the island two things arguably

it could

to influence one would be that and the

other would be whether that's 10% or 20%

so what are the mechanisms available to

a central bank to influence the money

supply because the more money you have

in an economy as I say the more it's

going to fight the limited supply of

goods and services on this island and

that's going to tend to push up the

price so that has an inflationary impact

okay very quick summary and we're seeing

some of this in action sort of at the

moment so basically three tools that can

be used to influence what's going on in

my scenario here if you're a central

bank number one is um something called

the discount rate all right basically in

short there are io u--'s out there that

don't carry an interest rate okay and

the way that the central bank can

influence that is if I asked you what

you would effectively what you would

deposit now to get a thousand pounds in

a year's time

if interest rates in the meantime 5%

then the answer is right now you only

need to pause it around nine hundred and

fifty two pounds okay and there are

financial instruments out there

io u--'s bonds they don't carry an

interest rate you buy them for one price

and cash them in another political

discount instruments and basically the

price is influenced by that money market

interest rates so central banks can

influence the size of that discount rate

they can not - in practice this bit of a

clumsy tool but they can do the second

thing they can do on my little island is

to change that reserve rate if you make

banks hold back more money who knows if

you up the reserve rate from ten to

twenty percent you instantly shrink

potentially okay your monetary base now

that's a pretty blunt tool it's not done

normally very often that way you can see

that under fractional reserve banking

the fraction matters okay because I

talked about creating a thousand pounds

with a rate of 10 percent 500 pounds the

rate twenty percent so that's a tool

number two and tool number three which

is the one that's used most often it is

the open market operation which is a

grand sounding title for what boils down

essentially to buying and selling bonds

okay

I'll just wrap up by explaining how that

works now I'm not going to drift into

Operation Twist or quantitative easing

because other videos on those precise

topics but in essence the other way you

can influence the money supply as a

central bank is by buying and selling

the government io u--'s if you like

here's the principle okay if you sell a

lot of government io u--'s people want

to buy them because they're safe they're

a nice place to put your money

especially they're issued by the

American or the UK government for

example so the idea is you sell io u--'s

commercial organizations and banks bid

for them and buy them that sucks

money out of the banking system into the

central bank okay

reducing the supply of money in the

economy because that money is being used

to pay for these IOUs

all right and if there's less money in

the economy then the price of it will

change okay so the theory is that

interest rates will rise slightly so by

basically selling io u--'s okay that's a

government

IOU use the idea is that you t-bills and

so on you suck money out of the banking

system because people got to pay for

them so now they want to pay for them as

a kind of safe haven and so on and

that's going to reduce the money flowing

around the banking system and therefore

increase the price of money so that will

have an impact all right alternatively

if the government fired central bank

decides to start buying back these IOUs

paying them off if you like that's going

to release central bank funds and via

the people you buy them into the economy

that means there's more money flying

around the economy in theory and that

will tend more money to push the price

down okay

so that will tend to reduce the price of

money or reduce interest rate right so

basically those are the three main

mechanisms by which the central bank

will attempt to influence supply and

potentially the price of money as well

and as I say the one that tends to use

most commonly at these three weapons is

that one