How commercial banks create money

Commercial banks can create money if they give out loans and the loan client deposits the money in the bank or another bank. Generally, it is the central bank that creates money through its currency printing subsidiary. Therefore to ensure the control of the supply of money, the central bank ensures that banks reserve a fraction of their deposit instead of providing them as loans. Note that creation of money is different from how banks make money.

The cash reserve ratio

To ensure that commercial banks don't give out all depositor's money as loans, the central bank of a country usually has a guideline on the minimum amount that should be reserved in the bank. These reserves can be in the bank vault, at other banks, through short-term securities, and with the central bank. When the supply of money is high in an economy the Central Bank will increase the cash reserve ratio (CRR) and vice versa. 

Therefore, an increase in this ratio means that the amount of money commercial banks can create will reduce. A reduction in the CRR will increase the amount of money available for banks to give out as loans and increase the money they create. For example, if the total deposit liabilities of a banking institution are 200 million Naira and the CRR is 10 percent. It means that the bank will have a total of 180 million Naira to give out as a loan. However, if the ratio increases to 15 percent, the money available for loans will be 150 million Naira. That is a reduction of 30 million Naira. In Nigeria, the current cash reserve ratio is 32.5%.

Procedure for bank creation of money

To explain how banks create money, we will make use of three banks. Let's call them banks A, B, and C. Also, it is assumed that the loan given to a client by bank A is deposited to bank B by the client, and so on. More so, let's assume a cash reserve ratio of 10%. 

Assume bank A has a deposit liabilities of 500 million Naira. Therefore, its cash reserves shall be 50 million (that is, 10% × 500 million). The remainder of 450 million is given out as loans to various customers. Next, the customers deposited the money borrowed to bank B. This will imply that bank B has a deposit liabilities of 450 million. A cash reserve of 45 million will be kept by the bank and 405 million Naira will be provided as loans to their clients. These clients collected the money and deposited it to Bank C. The institution will keep 40.5 million and use the remainder of 364.5 million available for loans.