Money Creation by Banking System

What is Money Creation by the Banking System?

Banks can lend the money simply because they do not expect all the investors and depositors to withdraw what they have deposited at the same time. When the banks lend the money to any person, a new deposit is opened in that particular person’s name. Hence, money supply rises to old deposits + new deposit (plus currency).

Now, let us take an instance. Presume that there is only 1 bank in the nation. Let us structure a fictional balance sheet for this only bank. The balance sheet is a data that is recorded of assets and liabilities of any enterprise. Traditionally, the assets of the enterprise are recorded on the left hand side and liabilities are recorded on the right hand side. Accounting rules say that both sides of the balance sheet must be equal and have to tally or total assets must be equal to that of the total liabilities. Assets are items an enterprise possesses or what an enterprise can claim from others. In case of a bank, apart from buildings and furniture, etc., its assets are the loans given to public. When the bank provides a loan of 1,000 to a person, this is the bank’s claim on that person for 1,000. Another asset that a bank has reserves. Reserves are the deposits which commercial banks upkeep with the Central bank, the Reserve Bank of India (RBI) and its cash. These reserves are partly kept as cash and partially in the form of financial instruments that is – bonds and treasury bills that are issued by the RBI. Reserves are similar to deposits we keep with banks. We keep deposits and these deposits are our assets, they can be withdrawn by us. Similarly, commercial banks like State Bank of India (SBI) keep their deposits with RBI and these are called Reserves.

Assets = Reserves + Loans

Liabilities for any enterprise are its debts or what it owes to others. For a bank, the main liability is the deposits which people keep with it.

Liabilities = Deposits

The accounting rule states that both sides of the account must balance. Therefore, if assets are greater than liabilities, they are recorded on the right hand side as Net Worth.

Net Worth = Assets Liabilities

The above mentioned is the concept that is explained in detail about Money Creation by the Banking System. To know more, stay tuned to BYJUS.