{"id":9761,"date":"2022-09-07T22:28:10","date_gmt":"2022-09-07T16:58:10","guid":{"rendered":"https:\/\/aayushbhaskar.com\/?p=9761"},"modified":"2022-09-24T21:02:59","modified_gmt":"2022-09-24T15:32:59","slug":"central-banks-dont-lend-here-is-how-they-work","status":"publish","type":"post","link":"https:\/\/aayushbhaskar.com\/central-banks-dont-lend-here-is-how-they-work\/","title":{"rendered":"Central Banks Don’t Lend. Here is How They Work","gt_translate_keys":[{"key":"rendered","format":"text"}]},"content":{"rendered":"

\"\"Banking doesn’t work with money lending!\u00a0<\/span><\/em><\/p>\n

I’m sure you’d have heard this statement. Even top economists such as Prof. Hyman Minsky talk about the working system of banks and clearly state that Banks do not lend money. Sounds a bit confusing, right?\u00a0<\/span><\/p>\n

According to the traditional textbooks on introductory economics, banks are represented as financial mediators whose primary work is to connect the borrowers to the savers.\u00a0<\/span><\/p>\n

In simple words, banks are nothing but conceivable intermediaries in today’s evolving economy.\u00a0<\/span><\/p>\n

The whole banking process revolves around a pool of funds that involves an earning individual paid above the usual consumption needs, who deposit the additional money to an established bank. This is known as the reservoir of funds.\u00a0<\/span><\/p>\n

With these funds, the bank loans out to those whose income falls below the usual consumption need. So, the banks work on a fractional reserve banking system, through which banks lend more than the deposited sum.\u00a0<\/span><\/p>\n

But what if I say banks make more money when they lend?\u00a0<\/span><\/p>\n

Yes, this is a money multiplier effect that amplifies the financial cycle.\u00a0<\/span><\/p>\n

Speaking of lending money, today we are discussing how the central bank works when it doesn’t lend money.\u00a0<\/span><\/p>\n

So, let’s get started!<\/span><\/p>\n

How Does the Bank Work?\u00a0<\/span><\/h2>\n

It’s clear from above that the central bank’s lending capacity is entirely dependent upon the extent of customers’ deposits. And in order to enhance the lending limit, banks need to attract more customers for new deposits.\u00a0<\/span><\/p>\n

With this, it can easily be said that deposits create loans.\u00a0<\/span><\/p>\n

The bank’s lending process works on money multiplier theory, which functions consistently with fractional reserve banking. Here, only a fraction of the deposited amount needs to be held in cash or deposited in the commercial bank’s account at the central bank.\u00a0<\/span><\/p>\n

This amount is determined by the reserve requirements, whose reciprocal sum is considered the multiple of reserve that is the bank’s lending capacity.\u00a0<\/span><\/p>\n

Therefore, if the reserve requirement is specified as 10% and its multiplier is ten, banks can lend out ten times more than the reserves.<\/span><\/p>\n

Another factor that affects a bank’s lending capacity is the central bank’s monetary policy, which finalizes the decision on the increased or decreased reserve values. However, with the selective monetary policy authority and restriction on increasing the reserve, the only other way for banks to increase their lending capacity is by securing new deposits.\u00a0<\/span><\/p>\n

And as we know, loans are created with deposits, meaning banks need customers’ money to proceed with the loans.<\/span><\/p>\n

Strategy for Bank Loans\u00a0<\/span><\/h2>\n

In simple words, banks tend to make more money when they lend, which amplifies the financial cycle.\u00a0<\/span><\/p>\n

Banks are known to have the right to issue loans given by the government without securing the deposit in the first place. The lending amount of the banks is determined by the regulation and policies of the central bank.\u00a0<\/span><\/p>\n

However, the central bank also directs commercial banks to hold a certain amount of liquid capital, which can be cash or anything that can be quickly sold relative to the prior issued loan.<\/span><\/p>\n

Money Creation by Banks\u00a0<\/span><\/h2>\n

The lending strategy of banks is known for money creation, which arises mainly from two things. These are:\u00a0<\/span><\/p>\n

Double Entry Accounting\u00a0<\/span><\/h3>\n

In this method, to create new loan assets, the bank needs the creation of an equivalent liability. This becomes the new deposit in the bank created by the new loan.\u00a0<\/span><\/p>\n

For instance, suppose a bank lends Rs.100 to its customers, then it will create a new loan asset worth INR 100, which is the new deposit.<\/span><\/p>\n

Measurement and definition of money\u00a0<\/span><\/h3>\n

There are basically two forms of money:<\/span><\/p>\n