LOANS AND MONEY CREATION

The illustration captures the idea that “Money makes the world go round”, the name of a song
composed by Robert Kelly that has become a popular English phrase. The phrase can be used in a
number of ways, including using it to describe the role of money in the economic world. The earlier
process described suggested that an increase in the stock of high-powered money was the cause of
further lending. Consider, however, the possibility that instead of “Money Making the World go
Round” that “The (Economic) World Makes Money go Round”.

There is a problem with the illustration of the money creation process described earlier, in that
reference is made only to the potential supply of loans. Neither the demand for loans by borrowers
nor the willingness of the banks to make these loans was considered.

If, as is the currently the case in South Africa, debt repayments of many households as a proportion of
income are at unsustainable levels and the indebted wish to remedy the situation, it is possible that
there will be insufficient demand for loans. It is also likely that, under these circumstances, the banks
would not be willing to make further loans; the fact that the borrowers are already in a fragile
situation with regard to servicing existing debt increases the probability of default on any new loans
granted. Defaults represent a loss to the banks and they would accordingly be extremely cautious
before committing funds to such loans. More generally, banks would commonly only make loans
available to suitable borrowers and, if such borrowers are not in the market for loans, the loans will
not be made. Loans are often also supported by the pledge of collateral and if this is either not
available or is of insufficient value the bank will not entertain granting of new loans.

In practice banks actively seek out new loan business as this is, after all, the main source of their
profits. Should a borrower with a good credit profile and/or adequate collateral either apply to a bank
for a loan or be sought out by the bank, the loan will be granted without reference to the availability or
otherwise of excess reserves. The necessary reserves, as will be seen, can always be obtained. This
suggests that the money creation process can be viewed from the point of view of the demand for
loans and the banks’ willingness to lend rather than from the perspective of the simple availability of
excess reserves.

It is a fact that, within the banking system as a whole, new loans create new demand deposits. Let’s
use a few examples to illustrate this. Vuyo intends starting a small-scale manufacturing operation
specialising in clothing with an ethnic African theme, and requires funds to buy the necessary sewing
machines. Her parents, who have been customers at Nedbank for many years, are willing to provide
security for the loan by pledging some of their own assets as collateral. Nedbank’s loan officer has
taken a careful look at Vuyo’s business plan and is of the opinion that the venture is likely to be a
success. In short, Nedbank are willing to grant the loan, and open both a loan account and a cheque
account in Vuyo’s name, debiting the loan account and crediting the cheque account with the amount
of the loan. At this instant, with demand deposits regarded as being money, the increased balance in
Vuyo’s cheque account means that new money has been created.

Of course, the question arises as to what happens to this new money when Vuyo buys the sewing
machines, using the balance in her cheque account to make the payment. If the seller of the sewing
machines also banks with Nedbank there is no change in aggregate in Nedbank’s books; Vuyo’s
account will be debited and the seller’s credited, so total demand deposits held at Nedbank do not
change. If instead the seller’s account is held at another bank (say Absa) the situation is slightly
different. Vuyo’s account will be debited and the seller’s account at Absa will be credited, and the
cash settlement between Nedbank and Absa will take place as described earlier. In the banking
system as a whole there has been no change in total (new) demand deposits; the only difference is that
these are now held at Absa instead of Nedbank. You may be a little concerned that, in the example
being used here, no direct reference has been made to the fact that the banks will need to adjust their
reserves; this will be covered after another example of lending has been given.

Not all loans granted are done in the way described above. The type of ‘loans’ that private
households are most familiar with is the use of a credit card, and for businesses an overdraft facility.
These two facilities are identical in the sense that the ‘loan account’ is not opened until a transaction
takes place, and there is no matching cheque account in the case of a credit card or loan account in the
case of an overdraft facility. An example of this type of transaction would be a purchase made by a
customer using a credit card; let’s suppose that Bongani buys the new Nintendo Wii from Incredible
Connection using his Mastercard which is issued by Standard Bank. The Mastercard would, of
course, not have been issued unless the bank was satisfied with Bongani’s credit record. Using his
credit card for the purchase, since it involves payment at a later date, means that Bongani is
effectively taking a loan from Standard Bank. The loan is formalised when Bongani signs the slip or
enters his PIN (Personal Identification Number), thereby contracting to repay Standard Bank at the
agreed future date. This is the debit side of the loan transaction. The credit takes place through
settlement with Incredible Connection by crediting their bank account. It should be apparent from the
previous example that it makes no difference at which bank Incredible Connection have their account.
A new deposit has been created through the increased balance in Incredible Connection’s account and,
since bank deposits are money, new money has been created.

Required Reserves

A fundamental difference between the ‘loans-based’ and ‘reserves-based’ approaches to the creation
of money is that, in the loans-based approach, the process was not initiated with an increase in
reserves. This does not, however, alter the fact that banks are required to (or if not would choose to)
hold reserves against their total deposits. In both of the examples above if the borrower and the seller
(of the goods bought by the borrower) held accounts at the same bank there would be no change in the
actual reserves held by that bank, but its liquidity ratio would have fallen as a result of the increase in
demand deposits. These developments can be explained with the aid of the table below

Standard Bank Abbreviated Balance Sheet

Liabilities Rm Assets Rm
Deposits (old) 200 Balances with the SARB 20
(old)
Deposits (new) 10 Advances (old) 180
Advances (new) 10
___ ___
210 210

With a required reserve ratio of 10%, the balance sheet position prior to the new loan being made
would reflect liabilities of R200 million in the form of demand deposits and assets of R200 million in
the form of reserves on deposit of R20 million and loans of R180 million. A new advance of R10
million would increase both assets and liabilities, assets in the form of new demand deposits and
liabilities in the form of new loans. Although Standard’s balance sheet is ‘in balance’ in a trivial
sense, the liquidity ratio has fallen to 9.52% (20/210) which is below the required reserve ratio of
10%. Reserves are short by R1 million and this situation needs to be corrected. The necessary
adjustments are shown in the table below.

Standard Bank Abbreviated Balance Sheet

Liabilities Rm Assets Rm
Deposits (old) 200 Balances with the SARB 20
(old)
Deposits (new) 10 Balances with the SARB 1
(new)
Loan from SARB (new) 1 Advances (old) 180
___ Advances (new) 10
211 211

The additional reserves required would be borrowed from the Reserve Bank through the repo system
which is described below. Assets will have increased by R1 million in the form of reserve deposits at
the SARB, and this is matched by an increase in liabilities in the form of the loan from the SARB.

The situation is different at a micro level where the two parties hold their accounts at different banks.
As will be seen, however, the changes in the banking system as a whole are identical. Following the
initial granting of the loan and spending of the proceeds, the initial situation for the two banks would
be as reflected in the tables below, assuming that the seller has an account at First National Bank.

Standard Bank Abbreviated Balance Sheet

Liabilities Rm Assets Rm
Deposits (old) 200 Reserve Balance (old) 20
Less: Trns to FNB 10 10

Advances (old) 180

___ Advances (new) 10 190
200 200

First National Bank Abbreviated Balance Sheet

Liabilities Rm Assets Rm
Deposits (old) 200 Reserve Balance (old) 20
Deposits (new) 10 Plus: Trns ex Standard 10 30

Advances (old) 180

210 210

The initial new advance is made by Standard Bank, reflected by an increase in assets in the form of
new advances of R10 million. Since the seller does not have an account with Standard, however,
there is no corresponding change to liabilities. There is, however, an outflow of reserves; this arises
through the payments clearing system described earlier and reserves are transferred to First National
Bank in the books of the Reserve Bank. The changes to Standard Bank’s balance sheet have thus all
occurred on the assets side, with an increase in advances and a decrease in the reserve balance held at
the Reserve Bank. Changes to First National Bank’s balance sheet occur on both the assets and
liabilities side. Liabilities increase with the new deposit of R10 million and there is a corresponding
increase in assets in the form of new reserve balances.

The liquidity ratios, given by the ratio of reserves to deposits, of both banks have now changed.
Standard Bank now has a liquidity ratio of 5%, which is below the required reserve ratio of 10% and
is thus short of R10 million in reserves. First National Bank, on the other hand, has a liquidity ratio
of 14.29% and accordingly has excess reserves of 4.29% or R9 million. These excess reserves would
be offered for sale in the interbank market and Standard Bank would take them up, but this still leaves
Standard Bank short of R1 million in reserves and this amount would have to be borrowed from the
Reserve Bank. The changes in the banking system as a whole are thus identical in both cases.

The difference between the two systems of money creation may appear to be trivial as they produce
identical results; an increase in deposits of R10 million is associated with an increase in reserves of
R1 million. In the first case it was the initial increase in reserves which led to the multiple increase in
deposits, and in the second the increased reserves were the result of an increase in deposits. The
second case does, however, have the advantage of formally incorporating the demand side of the
market for bank loans as well as the possibility that the banks may not be willing to extend the
additional loans. Further, as will be seen, the operation of monetary policy in South Africa is easier to
understand in terms of the second approach.

With money being created in this way the money supply is referred to as being endogenous since it is
determined within the system by the demand for loans. The concept of the money multiplier becomes
meaningless as it is simply a passive ratio of the total money stock to the stock of high-powered
money and cannot have any “multiplying” effect.