The process of credit creation explained?

Question

commercial banks have a liquidity ratio of say 10 percent the remainder 90 they loan out as a profit motive.

if the government wants to build a road it may need 10bn pounds which it debit in its account in the BOE (bank of england) and uses to pay for i.e labour, this 10 bn pounds is spent by

these people and eventually ends up in the commercial banks who deposit it at their accounts in the BOE. At this moment in time the balances at the BOE remain

the same. But now the commercial banks have excess liquidity so they lend more to bring the liquidity ratio back to what they deem desirable so credit is created

and the money supply increases, this process can go on indefinetly so long as the liquidity ratioi is maintained.

Is this right????

Answer 1

The asset:liability ratio that a bank maintains is a probability calculation based on empirical experience. It's not a constant. The same principle allows airlines to sell 130% of capacity on some flights, and only 105% on others. You only get into trouble when events move outside the probability distribution.

Answer 2

There is more than one liquidity ratio in operation, enforced by central banks.  In UK, for most of the past 160 years since the Bank Charter Act of 1844, commercial banks have been required to hold 8 per cent of customer deposits as cash and a further 20 per cent as liquid assets.  These have normally been financial instruments with maturity less than 30 days, in the form of bonds, government stock and commercial demand debentures.

So long as a bank maintains these two ratios, it may lend its customers' deposits.  If those loans are then deposited with the bank, it need only maintain the 8 and 28 per cent ratios and lend the remainder.  The process can go on ad infinitum, except that some customers will eventually demand their deposits back and the process may need to go into reverse.

In principle, if only 8 per cent of deposits need be maintained as cash, then every £1 or $1 could generate £12.50 or $12.50 of loans, so long as a fraction of the loans are maintained as "near money" in the form of liquid assets.