[Song Seungseop's Financial Light] The Magic Wand of Profitable Banks: 'Credit Creation'

Money Grows Larger as It Passes Through Banks?
The Modern Economy's Rapid Growth Thanks to Credit Creation

Finance is difficult. It is filled with confusing terms and complex backstories intertwined together. Sometimes, you need to learn dozens of concepts just to understand a single word. Yet, finance is important. To understand the philosophy of fund management and to consistently follow the flow of money, a foundation of financial knowledge is essential. Therefore, Asia Economy selects one financial term each week and explains it in very simple language. Even if you know nothing about finance, you can immediately understand these 'light' stories that turn on the bright 'light' of finance for you.

On the 7th, a scene at a bank counter in Seoul as major commercial banks continue to lower loan interest rates and raise interest rates on regular savings and installment savings products. Photo by Kang Jin-hyung aymsdream@

[Asia Economy Reporter Song Seungseop] The four major financial groups?KB, Shinhan, Hana, and Woori?earned a net profit of 8.9662 trillion won in the first half of this year. They broke the record by surpassing last year's all-time high half-year net profit of 8.0909 trillion won by more than 10.8%. Especially, as the benchmark interest rate rose, banks engaged in lending operations generated huge profits. But how do banks make money so well? Is it simply because many people borrow money? The reason lies in the unique 'credit creation' process of the financial system.

Credit creation refers to the economic phenomenon where money increases beyond its original scale just by passing through banks. It means that simply by the existence of banks, there is more money than actually exists. First, you need to understand how banks make money. Banks keep customers' money on their behalf. Then, they lend customers' money to other economic agents. They receive interest from borrowers and pay interest to depositors. Banks earn interest margin by mediating this process.

Let’s take an example. Suppose Company A deposits 10 million won in Bank ㄱ. Bank ㄱ lends 9 million won out of the 10 million won to Company B. Company B deposits the borrowed 9 million won back into Bank ㄱ for future investment. Bank ㄱ then lends 8 million won of this money to Company C. Company C deposits this money back into Bank ㄱ again.

How is it? Bank ㄱ initially received 10 million won from Company A. However, the total amount lent out by Bank ㄱ eventually reaches 27 million won. The actual cash remaining in the bank vault is only 10 million won. The 17 million won looks like a kind of fake money created by the bank. This phenomenon, where money (credit) increases as banks repeatedly lend and accept deposits, is called credit creation.

The Secret to Modern Economy’s Rapid Growth: Credit Creation

Source: Bank of Korea

Does the credit creation process feel unreasonable? Do you think it would be more reasonable if banks lent only as much as the 10 million won they have? In fact, credit creation is an essential element that supports the modern economy and capitalism. Because of credit creation, many economic agents could borrow money when needed. Large-scale projects and investments requiring huge amounts of money were possible thanks to credit creation. The rapid growth of humanity was also due to the development of the financial system and credit creation.

But what if Companies A, B, and C rush to Bank ㄱ and request all their cash back? The bank would not have enough cash to return. To prepare for such situations, central banks operate the 'reserve requirement ratio' system. The reserve requirement ratio is the proportion of money that banks must keep in their vaults when they receive deposits. If the reserve requirement ratio is 50%, when a bank receives 10 million won, it can lend only 5 million won and must keep 5 million won in reserve. Usually, central banks like the Bank of Korea decide the reserve requirement ratio.

The credit creation system can also be used to control the speed of the economy. What if the central bank drastically lowers the reserve requirement ratio from 50% to 10%? Banks would lend more money. It would become easier to get loans. Economic agents would invest and consume more, and the economy would revive. Conversely, to cool down an overheated economy, the reserve requirement ratio can be raised. Banks would lend less money.

However, there has been much debate in academia about the impact of credit creation on the economy. Some critical views argue that credit creation can cause industrial imbalances or financial crises, while others claim that credit creation enabled 'disruptive' innovations.