A Short Note on Bank Credit & Accountancy

Credit Creation - Different Accounting But Same Substance

When banks 'lend' to a borrower, they pass the following entry in their books,

Dr. Loans & Advances a/c (new asset created)
Cr. Demand Deposits a/c (new liability of same amount created)

The direct meaning of the above entry is that banks do in fact create deposits in every act of lending. Now, this is not the case of bookkeeping practice determining the true economic nature of the event (despite what some Modern Monetary Theorists would say). Rather, the said money creation would theoretically still occur at the individual bank level even when the accounting would not permit the bank to create deposits through this above entry.

Consider a situation where the bank passes the entry in the following manner for loans advanced,

Dr. Loans & Advances a/c (new asset created)
Cr. Cash Reserves a/c (existing asset of same amount reduced)

Here, we are reducing a liquid asset (being the banker's balances of highly liquid checking accounts with RBI or other banks) to create another asset (being the loan asset). One might say that there is no money creation, since the banker has passed the accounting entry in a more 'correct' manner. Setting aside the fact that common practice involves the former entry, the economic transaction has not changed in either case. The form is different. The substance stays the same.

Note that even though resources of the bank have been reduced and lent out, the original claim of the depositor which financed the cash reserves still remains intact i.e. the resources are still available to the depositor for immediate use, despite the bank having lent out the money to another borrower. Hence, the view that no money creation occurs with the alternative accounting treatment is false. The new moneys lent out are equivalent to the creation of additional purchasing power in the economy, over and above the original claims against the bank that continue to circulate and effectively function as money substitutes.

Analysis - Economic Theory

This phenomenon of credit creation was covered exhaustively by the great Austrian economist Ludwig von Mises in his treatise - 'The Theory of Money & Credit'. In his view, the loan transaction does not fit the strict meaning of a credit transaction. This is because when the depositor makes a demand deposit (a highly liquid deposit like a checking/saving account), he does not sacrifice a present resource. The depositor believes he has liquid cash in immediate access. The sum represents his demand for money, not the amount of his savings. When the banker lends out such moneys as credit, there is no sacrifice on the part of the saver. The depositor is still in possession of the money reflecting in his account. Traditionally, a credit transaction involves an act of saving by one who sacrifices a present resource for another who acquire the present resource with the promise to return after a fixed duration with interest. How can the banker's lending be seen as a credit transaction, then? 

In a gist, there is no sacrifice of present resources on the part of the depositor, while the banker lends those moneys out to others on longer maturities. There is an asymmetry here. The function of banking is to manage this very asymmetry i.e. 'Maturity Transformation'.

Given this asymmetry, how does the bank survive? Applying a clever use of the law of large numbers (probability theory), the bank manages to stay solvent, since not all depositors would withdraw their money all at once, and with a large bank it is very much possible that debits (outflows) from the accounts of some depositors are counterbalanced by adequate credits (inflows) in the accounts of others. This is further aided by a mechanism of a centralised system of clearing and settlement among banks, which allows them to settle daily inflows & outflows of deposits on a net basis. If there is a shortfall of reserves in a bank due to slightly excessive outflows, it may also borrow in the inter-bank reserves market on extremely short maturities (like one day, one week, etc.)