LeoGlossary: Commercial Bank Money

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Commercial Bank Money is the currency of a nation under the fractional reserve banking system. This is in contrast to central bank money which is the portion of the money supply in the form of banknotes and coinage.

Here control over the money supply granted to the depository institutions who are responsible for making loans. They often do so in proportion to the reserves they are holding.

The creation of commercial bank money is loosely tied to the proportion of central bank money.


Central banks such as the Federal Reserve often limit the ability of commercial banks to loan, thus increase the money supply, based upon the reserves being held. These are deposits that commercial bank have on account. It is easy to see how deposits into a commercial bank can increase its ability to lend.

Another aspect, and part of the financial engineering of central banks, is the reserves that come from non-deposit activity. This has exploded with the introduction of quantitative easing (QE). When central banks engage in this, they swap securities on the balance sheets of commercial banks and replace them with central bank reserves.

Securities, either mortgage backed securities or U.S. Treasuries (or any sovereign debt) is not lent against. They do not factor in the level of loan-making a bank can engage upon.

When the central bank puts reserves on the balance sheet of banks, that factors into the lending requirements, theoretically enabling the banks to lend more, increasing the money supply.

Reserves are not part of the money supply. They are part of the monetary base (M0). Reserves are only help by financial institutions that have a master account with the central bank. These are bank instruments that can only be utilized for inter-bank activity. This means no broad economy activity such as paying rents, doing stock buybacks, or offering bonuses is possible.

Central bank reserves are also called non-cash deposits.

Failure of QE

The ability to increase the money supply through bank lending is a theory of QE. After two decades, the reality is much different. Central banks cannot force commercial banks to lend. It can increase the ceiling on loans yet it cannot push banks to utilize it.

When economic conditions turn sour, which happens when the business cycle reverses, banks have less incentive to lend. It is not in their best interest. Defaults tend to increase, putting them at risk with other regulatory entities. The tendency is to raise lending standards, require a larger down payment, and reduce credit lines. This is not conducive to monetary expansion in a time when it is needed most.

Central banks are prohibited under a fractional reserve banking system from putting money directly into the economy. Even banknotes are driven by the commercial banks, that being the intermediary that distributes the currency. For this reason, it can only operate indirectly, trying to get the banks to lend.

The Money Supply

The amount of currency, or legal tender, available is contingent upon banking lending. Credit is an important component to the system.

When a bank makes a loan, more of the currency, such as the US dollar, increases. The supply decreases when the principal is paid down (off) or default takes place. Money supply will follow the business cycle as lending increases during expansion yet decreases when the downhill move towards the trough is occurring.

These are liabilities on the bank's balance sheet. Under double entry accounting, it is offset by an asset, namely the note tied to the loan. It is not uncommon for banks to sell their loans to investment banks on Wall Street, turning the note into cash. This does not change the money supply, simply transforms the asset on the balance sheet.

Commercial bank money is the basis for a debt based monetary system. It is also what allows the system to operate on a global scale. Physical money is used in only a small percentage of the transactions and almost none of the settlement process. Digital currency, i.e. the dollar, is what is used for most of global trade.

All the balances for the money supply is maintained on commercial bank ledgers. These are the ones who are the intermediaries between the general public and the monetary system. They maintain the ledger, updating balances as settlement occurs. The central bank will also run a ledger off the banks in total although not breaking it down by individual account holder.


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