Why Loans Are Added as Deposits in Banking Systems
Understanding why loans made by a bank are added as deposits is fundamental to grasping the money
creation process in modern banking. Let’s break it down:
1. What is a Deposit?
A deposit is money a customer has in their bank account. Customers can withdraw or transfer
this money when they want. For the bank, it’s a liability because the bank owes this money to
the customer.
2. What is a Loan?
A loan is money the bank gives to a borrower. For the bank, it’s an asset because the borrower
must repay it with interest.
3. The Connection Between Loans and Deposits
When a bank gives a loan, it doesn’t usually hand over physical cash. Instead, the bank creates
a deposit in the borrower’s account:
- The bank approves a loan (e.g., ■10,000) and credits the amount to the borrower’s account.
- This ■10,000 becomes a deposit because the borrower can use it like any other deposit—by
withdrawing, transferring, or spending it.
4. Why Loans are Added as Deposits
- Money Creation: Loans create new money in the economy. The borrower’s account shows ■10,000,
even though this money didn’t exist before.
- Bank’s Balance Sheet: The loan is an asset (borrower owes money to the bank). The deposit is a
liability (bank owes this money to the customer).
- Circulation of Deposits: When the borrower spends the ■10,000 (e.g., to pay a shopkeeper), the
shopkeeper deposits it in their bank account, further increasing deposits in the banking system.
5. A Practical Example
- Initial Deposit: A customer deposits ■1,000 in Bank A. With a CRR of 10%, the bank keeps ■100
as reserves and can lend ■900.
- Loan Creation: Bank A lends ■900, creating a deposit in the borrower’s account.
- Circulation: The borrower spends ■900, which is deposited in Bank B. Bank B keeps ■90 (CRR)
and lends ■810.
- This process repeats, increasing the total deposits in the system.
Result: The initial ■1,000 leads to ■10,000 in deposits due to the money multiplier effect.
6. Why CRR Includes These Deposits
- The CRR (Cash Reserve Ratio) is calculated on the total deposits, including those created by loans.
- These deposits represent money that customers can demand at any time, so banks must maintain
sufficient cash reserves to meet those demands.
Key Takeaway
The reason loans are added as deposits is that bank loans create deposits. In modern banking, the act
of lending itself increases the deposit base in the banking system, and CRR ensures liquidity for
withdrawals.
Visualizing the Process:
- Loan issued → Deposit created → Spent → Re-deposited → More loans and deposits
- Each step increases the total deposits in the banking system while CRR ensures banks maintain liquidity
