Question Enn Finance & Economics

Bank lending and liquidity creation

What are the links between credit creation and liquidity creation by banking institutions?

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Answer Expert #27497

The primary function of banks is to create credit and ensure the flow of money through the processes of loans, investments, and advances. The commercial banks usually operate in a cycle where they have the power to lend money which is deposited and hence multiply the amounts of investments, loans, and deposits as well. They are able to create additional purchasing power through this credit, which means that an increase in bank credits lead to multiple banking deposits.

Commercial banks are the secondary source of money supply, as credit creation is their main functionality while the central bank has the responsibility of circulation of money in the economy, hence creating liquidity. Therefore, commercial banks are required to keep cash reserves with the central bank to ensure a smooth flow of liquidity for depositors.

Commercial banks create credit by two primary methods: by giving a loan and by purchasing securities. As such, a borrower who asks for a loan of £1000 would be credited with this amount in their account rather than giving them cash. The borrower then draws the cheques and those who receive the cheque amount, deposit the amount in their respective banks, thus creating more deposits. Further, when the person deposits this £1000 in their account, the bank only keeps a particular percentage of that amount as cash for day-to-day transaction while lending the remaining to further clients.

Similarly, when a bank purchases securities or even buys some assets, it simply credits the account of the sellers with that amount, thus creating deposits. Regardless of the fact that deposits are made in some other banks, it enhances the banking system deposits overall and stimulates the liquidation process.