You may be surprised to know that loans can create a lot more funds for any economy than deposits. You may tend to think how a loan can create deposits when money lending is actually giving away money from the depositor’s accounts in the banks. Well, there is a lot of economics behind it. It is true that giving away new loans create a new liability for the banks but at the same time, it also creates new assets in a roundabout way for the banking systems. It is complicated and needs a deep insight into it to know about science and economics.
The fact is that when a bank makes a loan to a borrowing customer it simultaneously creates a new credit and a new liability for both the borrower as well as the bank. In this process, the borrower is usually credited with a deposit in the account. This, in turn, incurs the borrower with a liability for the amount borrowed from the bank.
The bank on the other hand now has a new asset which is equal to the amount of the loan given out to the borrower. This asset is equal to the liability of the deposit account.
Capital and reserve requirements
There are four separate entries made for such lending that signify an increase in the corresponding categories. These entries say that the assets and liabilities of the bank, as well as that of the borrower, have grown.
- At this point, simultaneously two more different types of liabilities are created as well. There is a reserve requirement created as well as a capital requirement. However, these requirements are strikingly different from any standard financial liabilities because these are all regulatory liabilities.
- The reserve requirement is created when the bank creates a deposit which is, in turn, an indicator of the bank’s liability and on the other hand a capital requirement is created when the loan is issued which is actually the asset of the bank. This is because the bank expects that it will get back the amount lent along with something extra in the form of interest.
To put it in simple terms, loans heal to create capital requirements but deposits create reserve requirements for the banks.
The lending principle
If you want to have a fair idea about the lending principle, you can visit the official websites of banks and other financial organizations such as https://www.libertylending.com/ or any other. Ideally, the working principles of banks are regulated by the government and are slightly different from the working principle of private money lenders or any non-banking financial companies. As per the rule, banks need to retain some amount of its deposits as a reserve and the percentage is regulated and revised by the government from time to time depending on the present economic scenario. There are a lot of technical requirements by the regulatory authority to calculate this reserve requirement percentage.
To keep the calculations simple, assume that the reserve requirement is 10 percent, which is much higher than the actual percentage. This means that the bank invites a reserve obligation of $10 for every $100 deposit that it takes on. Moreover, as loans create more deposits, it means that a loan of $100 will create a required reserve liability of $10.
The capital ratio
In order to find out how well a bank is capitalized, the government has formulated Tier One and Tier Two Capital ratio. This combined ratio also has complicated angles to measure the eventual capital requirements.
However, to keep the calculations simple and make it easy for you to understand, if the above rate and examples are followed, then the bank loan of $100 will once again give rise to a governing capital liability of $10 for both Tier One and Two Capital.
- Taking all these things into consideration, you can now clearly understand that a $100 loan has created a $100 deposit which is actually a $100 asset for the bank in the form of a loan.
- , On the other hand, it has also created a liability of $120 that includes the deposit as well as the requirements for reserves and capital.
The process explained
For a common person with limited knowledge of economics and finance, it might seem to be a bad deal for the bank. On the contrary and after a deeper look into the matter you will find that it is not so bad a deal after all.
- Suppose that a bank starts off from the scratch and lends $100 to a borrower by crediting the deposit account of the borrower with $100.
- The next step of the bank is to figure out immediately the effective ways to meet the two new liabilities hence created namely the capital requirement and reserve requirement.
- The bank may have to sell shares to raise the required $10 capital or it may even retain earnings or raise equity-like debts.
- However, the best way for the bank is to charge the borrower an origination fee of 10% to create earnings immediately.
The last option is practiced by different banks to help them settle their desired capital requirements with this $10 fee that can be kept as their retained earnings.
An extraordinary way to create deposits
Ideally, a person asking for $100 loan may be offered $90 or even $80 by the money lender depending on their business policy. It means that they instantaneously create a deposit of $10 or $20 as the case may be when they create a loan account of the borrower. It, therefore, corroborates the fact that loans create deposits.
This is actually extraordinary to meet the capital requirement by discounting and creating a deposit from its own loan. This is the own money creation power of the banks and the money lenders. The eventual effect of it is that it reduces the liability of the bank but does not reduce its asset.
Daniel Ng is a freelance writer who has been writing for various blogs. He has previously covered an extensive range of topics in her posts, including business debt consolidation, Finance, E-commerce, and start-ups.