From Loan to Deposit: Deposit Creation by Banks and the Significance of Cash Reserves

Banks create deposits in the process of lending. Of the total deposits of the banking systems in India over 4/5th is generated endogenously within the banking system through credit creation. In the context of fractional reserve banking, the traditional description of banking as acceptance of deposits for the purpose of lending distorts the perspective in which economics of banking is perceived and analyzed. In the real sector liabilities create assets, whereas in the monetary sector, assets create liabilities. The reserve requirement of central bank directly affects banks deposit inter-mediation and checks bank leverage. In this context, the concept of asset based cash reserves appears more logically appealing than liability based reserves. As ownership of money equips the owner with the means to stake claim on the finite resources of the world, ability of banks to create money ex-nihilo, places them in a very special category of institutions.