The banks add to the aggregate means of payments available to the market. The contribution of banks to money supply is in the form of bank deposits. Broadly speaking, these deposits may be divided into two categories, namely cash deposits and credit deposits.
Cash deposits refer to that form of deposits which are created when clients bring cash to a bank and deposit the same with it. In this process, the public finds that there is no net addition to the means of payments possessed by it. There is only a change in their form; that is, some cash is replaced by bank deposits. Cash deposits may also be referred to as primary deposits.
The other category of deposits is more important for our purpose. A bank is a financial firm and has the objective of earning a profit income. Its main source of operating surplus is the difference between interest paid on its liabilities and interest earned from its assets. Cash balances appear on the asset side of its balance sheet, But it cannot earn any interest income from them. It must acquire other income earning assets for this purpose. It finds that the maximum income which it can earn is from the loans and advances given by it to its clients or borrowers.
However, loans extended by a bank to its borrowers result in the creation of deposits in favor of the borrowers and thus add to the means of payment with them. In other words, by giving loans, a bank creates deposit liabilities and thus add to the means of payments (i.e, money supply). The loan deposits so created are termed secondary deposits or derived deposits. Numerically, the addition to money supply is equal to excess of its deposit liabilities over its cash holdings. Since this addition takes place via loan-giving activity of the bank, the process is known as that of credit creation.
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The fact of credit creation by banks can be verified both with the help of theory and their balance sheets. As stated above, a bank is a financial firm and has the objective of earning a profit income. For this reason, therefore, a bank “borrows short and lends long”. In other words, it contracts liabilities which, on an average, have a shorter duration and it acquires assets which on the average, have a longer duration. Its assets are dominated by the category of “loans and advances” which bring a high interest income to the bank. Its liabilities are dominated by its deposit liabilities some of which are interest free while the rest of them carry comparatively low interest rates Therefore, the bank is interested in creating the maximum possible deposit liabilities (preferably of the demand deposit variety).
The fact of credit creation can also be verified by looking at the balance sheet of any bank. It is seen that the cash balances with the bank are always a fraction of its deposit liabilities. As a result, the bank provides the market a much larger amount of means of payment (in the form of bank deposits) than it takes away from it (in the form of cash balances).