Another proposal that has been made is the creation of a special central bank for NFIs, in which they should hold reserves. The direct impact on the lending capacity of NFIs and banks would be the same as if the NFI were to hold reserves with the central bank. The indirect effects would depend on whether the central bank sterilizes the reserve funds deposited with it or uses them to lend and carry out other activities that might be assigned to it. If the special central bank performs other central bank functions, such as lender of last resort or discount, its creation would introduce another element of potential credit expansion into the financial system. The creation of a new lender of last resort would increase the liquidity of all NFIs and could allow them to hold lower “excess” reserves than they would otherwise have been. Increasing the liquidity of the NFI could also lead the public to view the NFI`s liabilities as a better substitute for money, and could increase the ease with which the NFI could attract deposits from banks and hordes. More importantly, by lending to NFIs, the special central bank would provide them with assets that would allow them to increase their lending, although the NFI reserve ratio would give them some control over their lending. A full assessment of this proposal would require an analysis of the types of loans that NFIs would provide if their overall assets and liquidity were increased, as well as other issues that cannot be addressed here. The results of a reserve requirement for NFIs vary considerably depending on whether their reserves can be held with private banks or must be held with the central bank. If the first option is chosen, the imposition of reserve requirements will not, as explained in a previous section, lead to a decrease in the overall deposits of the banking system. However, the ratio of banks` term deposits to demand deposits would likely decline, although the decline could be slowed if the NFI were allowed to include term deposits in its reserves. In times of credit crunch, NFI may be in a strong position to attract bank deposits to itself by raising the interest rate on its liabilities. Due to institutional and legal constraints, banks may default on the higher interest rates of NFIs and consequently lose deposits to them.11 Non-food institutions, whose liabilities largely replace bank bonds, will redirect bank deposits more efficiently than those of life insurance companies offering more distant substitutes.
For the symmetry of terminology, a credit multiplier (m) can be defined for financial intermediaries: How does NFI affect the effectiveness of monetary policy? It has been shown above that adding the NFI to the financial system or its growth relative to banks can increase the credit multiplier of the financial system. However, as shown in Table 1, the NFI credit multiplier will be close to 1 for probable reserve ratios and repayments. Looking at the effect of the reserve difference discussed above, the effect of the growth in the relative importance of NFI on credit expansion continues to decline. The general conclusion that could be reached – although any specific statement depends on the magnitude of the significant variables in each country – is that the growth of the NFI relative to the banking system increases the potential capacity of the financial system to develop credit, i.e. the credit multiplier of the financial intermediary, but not at an alarming rate for the reasonably expected values of the variable. Indeed, the growth in NFI assets partly reflects the Community`s desire to hold a larger share of its savings in the form of financial claims, given that Community assets are reaching higher levels, and thus partly justifies some credit expansion. I. The banking system can increase its lending and investments (y) several times (m) an increase in its reserves (x)14 Suppose the central bank requires all banks to maintain a 10% ratio in their reserves. How much credit would be created if someone deposited £500 at HSBC London? Total credit creation = 500/0.1= 5000. This means that the total credit creation of money is £5000.
Money multiplier = 1/0.1= 10. This means that for every £1 £10 in the economy is generated by credit creation. Banks use the deposits they hold with them to lend. However, you cannot use all deposits to lend. The law requires banks to hold a certain minimum proportion of their deposits in the form of reserves. This fraction is called the legal reserve ration (LRR) and is determined by the central bank. Bank deposits play a crucial role in the credit creation process. Most often, these bank deposits are used to make money transfers from one account to another. This makes it one of the most common forms of money. Since banks can easily deposit bank deposits, this has resulted in liquidity accounting for a relatively small share of all money circulating in an economy.
The value of the non-bank financial intermediary multiplier (non-bank multiplier) depends on the percentage of reserves that NFIs hold on their liabilities and the proportion of their loans and investments that return as deposits in these institutions. The higher the reserve requirement ratio and the lower the yield, the lower the non-bank multiplier. The formal relationship between these variables and the non-bank multiplier is described in the notes. The non-bank multiplier values for different reserve and redemption ratios are shown in Table 1. In most countries, the likely values of the non-bank multiplier appear to be between 0.8 and 1.3. With a low reserve ratio and low yield – which is the most common situation – the value of the non-bank multiplier will be close to unity. This means that NFI can increase its loans and investments by an amount roughly equivalent to an increase in its deposit liabilities. Demand deposits are an important component of the money supply, and the expansion of demand deposits means the expansion of the money supply. The entire banking structure is based on credit. Credit basically means getting purchasing power now and promising to pay in the future.
Bank credit refers to bank loans and advances. Conversely, the Fed increases the reserve requirement to reduce the amount of funds banks must lend. The Fed uses this mechanism to reduce the money supply in the economy and control inflation by slowing the economy. Banks may face constraints on the amount of loans they can create, as they may have to choose which customers to lend to. The reason for this may be that banks do not want to lend to someone who is unable to repay or who has an increased risk of repayment. This process takes until the first primary deposit of Rs. 1,000 and the initial additional reserves of Rs. 800 result in additional deposits or derivatives of Rs.
4,000 (800+640+512+…). V. It is now possible to calculate the net change in loans of financial intermediaries (z) resulting from a transfer of a deposit from a bank to an NFI (x`). All NFI reserves should be held in the form of demand deposits with the banking system. The switch from a bank deposit to an NFI deposit is represented by a positive number and the reverse movement by a negative number. The value of z depends on the reserve ratio of the NFI (r`), the banking system`s reserve requirement ratios to demand (rd) and term (rt) deposits and the percentage of deferred bank deposits that are term deposits (j). Replacing points (ii) and (v) with (i) gives the net change in financial intermediary lending caused by a transfer of deposits from banks to the NFI: this is a hypothetical example and not what happens in the real world. This is intended to explain the theoretical basis of credit creation. Suppose the bank is obliged to keep 20% of the deposits on its reserves in case customers want to withdraw their money.