REVERSAL POINT
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[Note] Fractional Reserve Banking System: Money Creation & Destruction

 
The underlying mechanism of money creation rests on the business model of banking/depository institutions. Depository institutions’ business model is simple [1]: besides equity, banks use customer deposits to fund their profit-making activities, lending; and while paying depositors short-term interest rates, charge long-term interest rates to borrowers. Banks make profits by exploiting long-short interest rate spreads.  In addition to profits made from interest rate spreads, their lending activities create layers of loans that add money—additional currency in circulation and deposits, from a macro perspective. In brief, the banking system creates additional money by transforming its own liabilities into others’ liabilities—in other words, from deposits to loans.

In this simple banking business model, regulators can put limits on banks’ activities through two measures: regulatory reserve requirements that require banks to reserve a fraction of their deposits; and capital requirements that require banks to allocate sufficient equity capital per the risk profiles of their asset portfolios. For illustration purposes, we will focus exclusively on regulatory reserve requirements.

Money Creation

Suppose the regulatory reserve requirement is 10%. For the sake of illustration, let us contemplate a simplistic world where there is no cost. Figure A illustrates the following transactions, which flow in order from right to left.

Let’s say $100 came into the banking system as a deposit. Insofar as satisfying the 10% regulatory reserve requirement, banks can lend up to 90% of the deposit to earn the long-short interest rate spreads. The $90 in lent money circulates into the economy through lending activity.

​Ultimately, with some leakage, some portion of the $90 would end up returning to the banking system as a deposit. Suppose $80 goes into bank B. Bank B can then lend the new deposit complying with the regulatory reserve requirement: this time, up to 90% of $80, which is $72. At this stage, the initial deposit of $100 created lending of $90 and $72—therefore, $162 in total, resulting in two rounds of lending. On its liabilities side, the bank has added a new deposit of $80 to the initial deposit of $100. This can go on and on as long as the banking system finds borrowers and receives new deposits. This is called a money multiplier, and illustrates how fractional reserve banking systems create money: money includes deposits as well as currency in circulation. At the time of each loan, it is uncertain whether the borrower can maintain the ability to repay the debt in the future. Therefore, this picture reveals how uncertain, unwarranted lending activities create money.

Money Destruction

Now let us review debt repayment, which will illustrate the money destruction process that Minsky addressed. Say that in the past a borrower had taken out a loan of $90 in order to acquire an investment asset. Now suppose, after having yielded a predetermined target profit, the asset no longer yields a desirable return and the borrower is ready to repay the loan. Now we will observe the relevant transaction through the transformation in the balance sheet of the borrower and the lender. For simplicity, we will focus only on the items relevant to the loan transaction and ignore the rest.

​Let’s assume that the borrower found a buyer and managed to sell the collateral for a price above the loan outstanding balance, in this case, the lump sum repayment of the original principal, or $90. The relevant part of the collateral value appears in its assets compartment with its corresponding loan on its liability side. First, at the borrower’s balance sheet, the asset is disposed in exchange for cash; then, using the cash, the loan is to be repaid; and next, on the assets of the bank, the repayment will replace the loan with cash. Now the repayment is complete; and the lending of $90 was destroyed through the borrower’s credible act of repayment by design.

Note:

[1] Given the precondition here that under normal circumstances, long term interest rates are higher than short term interest rates, this is a rather simple business model. Having said that, of course, in lending activities credit management is a complex matter.
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