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Credit Creation and Allocation

November 3, 2011

“Subject only but crucially to confidence in their soundness, banks extend credit by simply increasing the borrowing customer’s current account, which can be paid away to wherever the borrower wants by the bank writing a cheque on itself’. That is, banks extend credit by creating money.” Paul Tucker, Deputy Governor at the Bank of England, member of the Monetary Policy Committee, 2007

My post Where does the Money Come from? explains how commercial banks create credit in the act of creating a loan. The standard textbook ‘money multiplier’ explanation of Fractional Reserve Banking can control the total amount of credit extended by controlling the amount of ‘base money’ and setting the reserve ratio. However it turns out that if this were ever true it is out of date [NEF2011].

Currently in the UK there are no direct compulsory cash reserve requirements placed on banks and building societies.

While it is true that Basel Accord capital adequacy rules can limit the amount of credit extended as a proportion of a bank’s reserves, retained profits allow reserves to grow and hence the total amount of credit extended can go on growing.

Moreover, as Werner convincingly shows [Werner 2005], demand for credit always outstrips supply, and so credit is rationed by the banks. This means they can allocate it in ways that are most profitable to them, but at not necessarily socially optimal. Werner distinguishes between loans made (and hence credited extended) for:

a. Consumption – leading to consumer price inflation (since in it self it does not increase productive capacity)

b. ‘Investment’ in existing assets such as land, housing, stocks and shares etc., the supply of which is inelastic. This does not contribute to GDP but does cause asset price inflation. More importantly it leads to bubbles and hence crashes like the 2008 banking crash.

c. Investment in industry – which he claims is not inflationary (and of course creates jobs).

Unsurprisingly banks prefer to advance secured loans (typically secured on the asset being purchased). Also the Basel rules risk weight different types of loan (e.g. business loans 100% and mortgages 35%), so that unless the interest rate on a business loan is at least 100/35 = about three times that on a mortgage it pays banks to prefer mortgages to business loans. For both these reasons banks go for loans for the purchase of existing assets. As we see in my post Asset Bubbles, the perception that secured loans are less risky than unsecured loans may not be correct.

Werner advocates [Werner 2010] direct quantitative controls on the amount of credit banks are permitted to extend, and a strong preference for business loans. He points out that such restrictions were applied in Western economies up until the 1970s and have been used successfully in Asia much more recently.

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