Introduction
Commercial bank money remains a central pillar in contemporary economies as it is an essential form of money to finance most transactions in an economy. While central bank money is physical currency and the reserves are maintained by the commercial banks at the central bank the commercial bank money is generated by the private banks through credit creation.
This paper seeks to review in detail commercial bank money from its creation process and role in the economic system to its effects on the financial system and the difficulties associated with it.
Money Definition and Categories
Central Bank Money
CB money includes the cash in circulation as well as the money deposited with the commercial banks by the central bank. It includes
Physical Currency Notes and coins
Reserves A balance that a commercial bank maintains at the central bank for the purpose of clearing cheques and other transactions and satisfying legal and regulatory prescriptions.
Commercial Bank Money
Commercial bank money is on the other hand money deposited by commercial banks.
Demand Deposits
Current accounts that allow one to withdraw on demand.
Savings Deposits
Checking accounts also enables the account holder to earn interest on the balance in the account but the number of transactions they allow is small.
Time Deposits
Special types of accounts that pay a higher interest in return for a certain period of being locked.
Creation of Commercial Bank Money
Fractional Reserve Banking
Commercial bank money is primarily created through the process of fractional reserve banking. In this system some of the deposits are kept by the banks as reserves while the rest of the money can be lent out. This lending yields new deposits in the banking system thereby augmenting the monetary base.
Money Multiplier Effect
The money multiplier effect is the concept that an initial deposit will lead to multiple multiples in total money. For instance if the reserve requirement is 10% an initial deposit of $1000 can generate up to $10000 in new money through multiple rounds of lending and depositing.
Balance Sheet Mechanics
When a bank makes a loan it debits the borrower’s account by making a deposit which is considered a liability by the bank. At the same time the loan is recorded as an asset in the bank’s balance sheet. This double entry book keeping is the basis of money creation in the commercial banking system.
Functions of commercial banks in economy
Intermediation
Commercial banks are financial institutions that assist in mobilizing funds from those who have surplus funds and those who have a shortage of funds. This intermediation is critical in the provision of funds to firms to undertake investments and individuals to fund large purchases.
Payment Services
Banks offer indispensable payment services that enhance the performance of payments through tools such as checks electronic transfers and debit cards. These services form the backbone of todays economy since they enable the transfer of money from one party to another.
Credit Creation
In this case banks facilitate the expansion of the economy by offering credit. Business lending enables capital investments in equipment and buildings technology and people while consumer credit enables investments in homes schools and everything else.
Risk Management
Insurance products such as derivatives and advisory services are also provided by banks for risk management. These contribute to the management of financial risks within and between various economic entities thus supporting economic stability.
Effect of Commercial Bank Money
Economic Growth
This paper aims to establish that commercial bank money is a factor in economic growth. Banks facilitate expansion and productivity by extending credit to various investments. However the downside is that there is a risk of asset bubbles and increased financial risk as a result of more lending.
Inflation
Commercial bank money or money supply influences inflation. When the money supply increases without the corresponding increase in goods and services money buys more hence increasing the prices. Central banks regulate and oversee the money stock to preserve price stability.
Financial Stability
It can be therefore concluded that the health of the banking sector is paramount in any country for the stability of the financial system. Bank failures in turn result in a loss of confidence leading to a shortage in the money supply as observed in a financial crisis. Policies have the primary objective of stabilizing the banking sector and eliminating threats to its stability.
Monetary Policy Transmission
The commercial banks act as agents through which most of the monetary policy is implemented. Interest rate changes and open market operations are among the tools that central banks employ to control the lending activities of commercial banks and consequently the economy at large.
Problems of Commercial Bank Money In light of the above there are several challenges and issues that can be discussed in connection with commercial bank money.
Regulation and Supervision
Sound regulation and supervision are crucial in the banking system since they will determine the strengths of a particular nation’s banking sector. Some of the duties include setting a minimum capital level stress testing and supervising risk exposures.
Digital Transformation
Digitalization of banking and the evolution of fintech present benefits and threats for stakeholders alike. While adopting digital platforms and leveraging Information Communications Technology Products (ICTP) can increase efficiency and make the services more accessible to clients there are also new challenges on cybersecurity and regulatory issues that need to be addressed.
Financial Inclusion
Providing equal access to an all extended population is a major problem. A major objective of financial inclusion is to ensure that individuals who have poor access to formal financial services can easily access credit save or make payments.
Shadow Banking
The shadow banking system having been defined to consist of all nonbank financial intermediaries can itself produce commercial bank monetary claims. However it can improve credit supply to the extent it also presents regulatory issues and systemic vulnerabilities.
Environmental Social and Governance (ESG)
Environmental and social considerations are becoming more apparent as banks continue to incorporate them into their credit granting process. UN Sustainable Development Goals may shape credit and investment the positive impact of which has to be balanced with the demand for new approaches to risk analysis and disclosure.
RealLife Applications
The 2008 Financial Crisis
The global financial crisis that was experienced in 2008 was a wakeup call to address problems of commercial bank money creation. This was evident by the fact that money and credit were boosted through excessive lending especially in the housing sector. The last event that happened was the bursting of the housing bubble which led to a drastic reduction in the circulation of money around the world and a consequent economic crisis.
Quantitative Easing
After the 2008 crisis central banks adopted measures of monetary policy called quantitative easing (QE). For example through the acquisition of government securities and other financial assets the central bank helped to increase lending by commercial banks to fuel economic growth.
Future Trends and Developments
Central Bank Digital Currencies (CBDCs)
CBDCs represent another trend that may bring about fundamental changes in the nature of commercial bank money. CBDCs are a digital form of central bank money that can be superior to commercial bank deposits in terms of their stability.
Blockchain and Cryptocurrencies
This paper looks at how blockchain technology and cryptocurrencies affect commercial banks as a threat or opportunity. They open up other possibilities for generating and transferring money but at the same time they challenge banking operations and raise issues of regulation and safety.
Green Finance
With climate change being a reality there is a growing focus on green finance in the world today. Lenders are creating products and services that finance environmentally sustainable initiatives and incorporating ESG considerations into credit and investment portfolios.
Financial Technology (Fintech)
Fintech is disrupting banking through new methods of developing controlling and transferring funds more efficiently. From peer to peer lending to robo advisors fintech is increasing peoples access to finance and
Historical Development of Banking Regulations
Banking regulation has progressed through the twentieth century in response to economic change and crises. During the early part of this century the creation of central banks sought to maintain the stability of the national economy through the supervision of commercial banks and monetary policy control. The Great Depression of the 1930s led to the development of more regulation in terms of deposit insurance and capital adequacy which led to the protection of depositors and confidence in banking.
A new era of international banking emerged after World War II and consequently there was a necessity for a mutual policy for regulation. Established in 1974 the Basel Committee on Banking Supervision was instrumental in the formation of the banking norms. Basel Accords especially Basel I II and III are guides to capital adequacy stress testing and market liquidity risks to enhance the stability of the global banks.
Key regulatory bodies and frameworks
National Regulatory Bodies Federal Reserve (United States)
The Federal Reserve is the central bank of the United States with its responsibilities being to supervise and regulate other commercial banks implement monetary policies and offer banking services.
European Central Bank (ECB)
The ECB regulates banking and coordinates monetary policy in the Euro Area as well as supervises the stability of the financial market within EU member states.
Financial Conduct Authority (FCA)
The FCA has the objective of shielding consumers and maintaining the integrity of the market whereas the PRA is responsible for the prudential regulation of the banks and their stability.
International Regulatory Bodies
Basel Committee on Banking Supervision (BCBS)
The BCBS maintains a current cooperation framework to address the banking supervisory issues and establishes guidelines for worldwide banking regulation.
Financial Stability Board (FSB)
The FSB leads the ongoing work to strengthen the financial system in the global context contributing to the creation of appropriate and efficient regulatory supervisory and other financial policies.
International Monetary Fund (IMF)
The IMF actively tracks economic trends around the world helps countries that experience financial difficulties and offers funds expertise and teaching to help members perform better.
Main areas for Bank regulation
Capital Adequacy
Capital adequacy means the requirements for banks to maintain a definite quantity of capital for their risk weighted exposures. This means that banks can make provisions for loss taking and survive during periods of economic downturn.
Tier 1 Capital
This is made up of common equity and retained earnings that cushion losses without a bank having to be closed.
Tier 2 Capital
The second one is the supplementary capital which includes subordinated debt and hybrids that can take losses in case of winding up but are not as permanent as Tier 1 capital.
Capital Adequacy Ratio (CAR)
One of the measures of a bank’s capital that is arrived at as a proportion of the risk weight of its credit assets. According to the Basel III agreement the minimum concentration of own funds is 8% but more stringent demands are made to systemically significant banks.
Liquidity Requirements
Liquidity requirements enable banks to ensure that they have adequate amounts of liquid assets in order to meet shortterm demands. Key liquidity measures include
Liquidity Coverage Ratio (LCR)
Requires banks to maintain adequate unencumbered liquid assets to meet their net cash flow needs under the specified stressed period of 30 days.
Net Stable Funding Ratio (NSFR)
Helps ensure that banks have sustainable and well diversified funding structures with regard to the funding of both its assets and off balance sheet activities within a longer term perspective.
Stress Testing
Stress testing can be done in an attempt to measure a given bank’s stability under different unfavourable economic conditions. The pressure tests are carried out on a regular basis with the purpose of evaluating the performance of individual institutions and the general state of the banking sector.
These tests are constructed in such a way that they simulate possible nominal shocks like severe recessions and credit share and foreign exchange market shocks which enables the discovery of whether a bank has adequate capital to meet the required adequacy ratio and adequate liquidity to meet its obligations under stressed conditions.
Consumer Protection
Consumer protection regulations help protect the rights of customers of banks to get their money’s worth and let the banks give them what they are supposed to get to the Books. Key aspects include
Disclosure Requirements
Lenders are advised to provide proper disclosure details of their charges interest rates and other written terms of their products and services.
Fair Lending Practices
This means that discriminatory lending practices are unlawful and that credit is extended fairly and evenly.
Deposit Insurance
Deposit insurance schemes guarantee depositors up to a certain limit in case of the failure of a bank act that keeps the able depositors confidence.
Challenges in Bank Regulation
Balancing Regulation and Innovation
As we have seen from the above analysis technological advancement has continued to advance at a very high rate within the financial industry which remains a challenge to the regulators. It is important to learn from emerging technologies so as to separate new opportunities from new perils that digital currencies and the like present.
The authorities need to encourage new entrants and experimentation while preventing new forms of financial products and services from destabilizing and eroding the solidity and soundness of the financial system.
Regulatory Arbitrage
Regulatory arbitrage is defined as the situation that delegates the operation of reducing a firm’s regulatory burden to banks within specific jurisdictions. This can erode the effectiveness of regulation and introduce new systemic vulnerabilities. This problem can be solved by better coordination and thus harmonization of regulation across different countries and their jurisdictions including those set out by the Basel Committee.
Impact on Commercial Banks
Increased Competition
Established banks today face stiff competition from the Fintech companies and the digital only banks who are steadily encroaching on the markets that were traditionally controlled by these established banks.
Cost Efficiency
Digital banking operations also lead to lower operational expenses since operations may be automated and the need to have many branches may not be as necessary.
Customer Experience
The common trends are increased and the quality of service delivery is improved by making banking activities more accessible to the customers.
Cyber security Risks
As the usage of online markets escalates there are more hacking incidents which implies that banks must incur significant amounts to put in place proper cybersecurity systems to guard clients data as well as the reliability of their systems.
Regulatory Considerations
With the emergence of new activities and banking tools also come new risks for regulators to navigate as well as new rules and effective regulation of all market participants. Key regulatory considerations include
Micro finance
Microfinance institutions sometimes called microbanks are organizations that provide a small volume of financial services and products with a special focus on credit at low levels of starting rural poor and entrepreneurs of small businesses to enable growth and building up sustainable income generating enterprises.
Digital Financial Services
Mobile payment services such as MPesa in Kenya for instance provide a way of paying for goods and cash as well as through mobile money thus increasing financial access in countries with poor or no wall.
Due to the financial constraints and limited or no access to banking facilities in most developing or even some developed countries there is a need to come up with an alternative way of paying for goods and to be able to receive cash through mobile money facilitated
Financial Literacy Programs
The actions that can be envisaged in schools in order to improve the understanding of different types of personal finance and services can contribute to the growth of the extent of opportunities for individuals to make a correct choice and use the services that are provided most effectively.
Public Private Partnerships
The roles achieved through such involvement can include efficient use of technology and resources for the implementation of suitable and convenient inclusive finance solutions such as ID systems and e payment systems in cooperation between governments banks and Fintech startups.
Now that we have discussed the nature of commercial banks let us establish their involvement in other aspects. Commercial banks play a critical role in advancing financial inclusion by
Developing Inclusive Products
Some of the potential is that banks could develop products and services to target such customers for instance basic savings accounts microcredit and remittance services.
Leveraging Technology
By transforming operations through digital banking and fintech the new technology can also target customers who have limited access to banking agencies.
Collaborating with Stakeholders
To support the success of financial solutions and build sustainable systems governments NGOs and other fintech firms should team up with international organizations.
Promoting Financial Literacy
Aside from loans insurance and other financial services banks can also offer education in finance aimed at helping individuals and other businesses become financially literate.
Conclusion
Available data reveal that commercial bank money is an essential and vital factor in the structure of the contemporary financial system since it contributes to economic growth stability and development. For policymakers economists businessmen and users it is important to know how it has been developed how it works and what effects it causes.
Preparing for different trends and challenges that require coverage of commercial bank money in the future financial environment will be necessary to function effectively in the constantly changing world economy. The various types of commercial bank money will help in identifying the areas where it plays a crucial role and the forces at work that affect the performance of commercial bank money.
As we look to what comes next banking fintech and regulation will continue to evolve and create new opportunities and challenges for all of the players incumbents and insurgents alike.
