Chapter 8 — Money, Credit, and Banking

Core question

How can banks create liquid deposits while holding risky, long-term assets—and why does that arrangement require capital, liquidity, confidence, and supervision?

Learning outcomes

You will be able to:

• distinguish money, income, wealth, and credit;
• record a loan and deposit on a bank balance sheet;
• explain the constraints on deposit creation;
• separate solvency, liquidity, credit, and interest-rate risk.

1. What money does

Money serves as:

• medium of exchange — accepted in payment;
• unit of account — common measure for prices and debts;
• store of value — transfers purchasing power through time.

Money is not the same as wealth. A bank deposit is money for the customer and a liability for the bank. A house may be valuable wealth but is not normally money because it cannot settle a purchase immediately at par.

Liquidity asks how quickly and reliably an asset can make payment without a large price loss.

2. Read both sides of the balance sheet

Campus Bank begins with:

Accounting identity:

Equity absorbs losses first. If assets lose £6, equity falls from £10 to £4. Deposits do not automatically fall with the asset value.

3. A bank loan creates a deposit

Suppose the bank approves a £5,000 business loan and credits the borrower's account.

The banking system has created a loan asset and deposit money together. The bank did not hand over an existing depositor's named funds.

When the borrower pays a supplier at another bank, reserves must settle between banks. The originating bank therefore needs funding and liquidity even though lending created the deposit.

4. What constrains credit creation

Banks cannot create unlimited deposits. Constraints include:

• creditworthy demand for loans;
• capital requirements and expected losses;
• liquidity and settlement needs;
• funding cost and interest-rate risk;
• regulation, supervision, and internal risk limits;
• the central bank's policy stance;
• confidence of depositors and markets.

The textbook multiplier 1/reserve ratio describes a special system with fixed reserve ratios, full redepositing, no cash leakage, no capital constraint, and willing banks/borrowers. It is useful for one mechanism, not a mechanical description of modern lending.

5. Four different risks

A solvent institution can be illiquid; a liquid institution can still be insolvent. Emergency lending addresses liquidity, not an unrecognised hole in asset value.

6. Maturity transformation and runs

Banks issue short-term, withdrawable deposits and hold longer-term loans or securities. This supports credit but creates a coordination problem.

Deposit insurance, liquidity buffers, lender-of-last-resort facilities, resolution regimes, and credible supervision reduce—but do not remove—risk.

7. Evidence case: Silicon Valley Bank

The Federal Reserve's 2023 review identifies a combination rather than one cause:

• rapid asset growth from about $71 billion to more than$211 billion during 2019–21;
• concentrated reliance on uninsured deposits;
• weak liquidity and interest-rate risk management;
• long-duration assets exposed to rising rates;
• delayed and insufficient supervisory escalation;
• more than $40 billion of deposit outflow on 9 March 2023, with much larger requests expected the next day.

The lesson is a balance-sheet chain:

concentrated funding + duration loss + weak liquidity plan
→ confidence shock → rapid withdrawals → forced closure

This official review does not imply that every bank with bond losses will fail; funding structure, hedging, capital, liquidity access, governance, and supervision matter (Federal Reserve, 2023).

8. Central banks

Central banks typically support:

• monetary-policy implementation;
• settlement and payment systems;
• currency issuance and reserves;
• emergency liquidity under defined conditions;
• financial stability, often alongside other authorities.

These roles can conflict. Emergency support may prevent disorderly failure but weaken incentives if owners and managers expect rescue. Design therefore separates liquidity support, loss absorption, supervision, and resolution where possible.

Worked stress test

Starting equity is £10,000. The bank experiences:

• £4,000 credit losses;
• £3,000 decline in bond value;
• £12,000 deposit withdrawal settled from £20,000 reserves.

After losses, equity is 10 − 4 − 3 = £3,000. The withdrawal reduces reserves and deposits equally; it does not itself reduce equity. Remaining reserves are £8,000. The bank is still positive-equity in this simplified accounting but has a thinner solvency and liquidity cushion.

Practice

1. Record a £2,000 new loan and deposit.
2. Record repayment of £500 principal.
3. Apply a £1,200 loan loss and identify the first buffer.
4. Explain why a withdrawal is different from a loss.
5. Diagnose whether each event is credit, liquidity, duration, or solvency risk.

Quick check

• Deposits are money for customers and liabilities for banks.
• Lending can create deposits; settlement still requires liquidity.
• Capital absorbs losses; reserves settle payments.
• Solvency and liquidity are distinct.
• Bank failure is usually a chain of interacting vulnerabilities.

Next: trace shocks and monetary policy through the whole economy.