Conversion of 

off-balance/ledger to 


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The Differences Between Off-Leger and Off-Balance in Banking

A. In the context of banking, "off-ledger" and "off-balance" funds operate distinctly:

The terms “off-balance sheet” and “off-ledger” are often used in financial contexts to describe different types of accounting treatments and disclosures. Here’s a detailed explanation of each term and the key differences between them:

Off-Balance Sheet

Off-balance sheet items refer to assets or liabilities that do not appear on a company’s balance sheet. These items are typically contingent or notional in nature, meaning they represent potential future obligations or rights rather than current ones.


  1. Contingent Nature: Off-balance sheet items often involve contingent liabilities or assets that may or may not materialize, depending on future events.
  2. Common Examples: Loan commitments, guarantees, derivatives, operating leases, and certain types of securitizations.
  3. Purpose: These items are used to manage risk, leverage, and liquidity without impacting the apparent financial position of the entity on its balance sheet.
  4. Disclosure: While not included in the balance sheet, these items must be disclosed in the notes to the financial statements as per accounting standards, to ensure transparency.


Off-ledger items are not commonly defined in traditional accounting but generally refer to funds or transactions that are not recorded in the primary ledgers of an entity. These might be used internally or externally but are not part of the formal accounting records.


  1. Internal Records: Off-ledger items may be tracked internally for management purposes but are not included in the official financial statements.
  2. Informal Nature: These items can include informal commitments, internal adjustments, or management estimates that are not formalized in the accounting system.
  3. Purpose: They can be used for internal decision-making, budgeting, or planning without affecting the official financial records.
  4. Disclosure: These items are typically not disclosed in formal financial statements or notes, as they do not conform to standard accounting practices.

Key Differences

  1. Accounting Treatment:
  • Off-Balance Sheet: These items are recognized and disclosed according to standard accounting rules, often appearing in the notes to financial statements.
  • Off-Ledger: These items are not recognized in the formal accounting records and are not subject to standard disclosure requirements.

 2. Transparency and Disclosure:

  • Off-Balance Sheet: There is a requirement for transparency and detailed disclosure in the notes to the financial statements.
  • Off-Ledger: These items are typically internal and not disclosed to external stakeholders.

 3. Regulatory Compliance:

  • Off-Balance Sheet: Subject to regulatory oversight and must comply with accounting standards such as GAAP or IFRS.
  • Off-Ledger: Not typically subject to the same regulatory requirements as they are not part of formal financial reporting.

 4. Impact on Financial Ratios:

  • Off-Balance Sheet: Can influence investors’ perception of risk and leverage without affecting the primary financial ratios directly.
  • Off-Ledger: Do not impact financial ratios as they are not included in formal calculations.

Off-Ledger Funds in Banking: 

In the banking sector, off-ledger funds or off-balance sheet funds, might involve transactions or accounts that are kept separate from the bank's main accounting system. They are assets or liabilities that are not recorded on the balance sheet but can significantly impact a bank’s financial condition. These items often represent potential obligations or contingent assets that may become actualised under certain circumstances. For example, a bank may have special funds or accounts for internal purposes like employee welfare or discretionary expenses, which are not included in the bank's primary financial statements.

Off-Balance Sheet Funds in Banking: 

Banks often engage in off-balance sheet activities like issuing letters of credit, derivatives trading, or securitization of assets. An example is contingent liabilities like letters of credit, where the bank commits to paying a beneficiary if certain conditions are met. These are not recorded as liabilities on the balance sheet until the conditions are fulfilled, but they represent potential obligations.

In both cases, these practices can impact a bank's apparent financial health and risk profile. Off-balance sheet activities, in particular, can significantly increase a bank's risk exposure without affecting its reported financial metrics like debt levels.

B. In the realm of central banking, the concepts of "off-ledger" and "off-balance" activities can be quite different from commercial banking:

1. Off-Ledger in Central Banks: Central banks may engage in off-ledger operations when dealing with unofficial or non-public transactions. These might include confidential agreements with other nations or central banks and certain types of currency swaps. For instance, a central bank might engage in a currency swap with another country's central bank as a part of a liquidity support agreement, but this may not be immediately reflected in the ledger.

2. Off-Balance in Central Banks:  Central banks might hold assets or liabilities off their balance sheets in various ways. An example is the use of special purpose vehicles (SPVs) to manage certain types of assets or liabilities. These SPVs can be used to isolate financial risks or for managing unconventional monetary policies, like quantitative easing. The assets held or liabilities incurred by these SPVs might not appear directly on the central bank's balance sheet.

Both off-ledger and off-balance sheet activities in central banking are subject to specific regulatory and oversight mechanisms due to their potential impact on national and global financial stability.

Differences between off-balance Sheets in Banks and Central Banks

In both commercial and central banks, the distinction between on-balance-sheet and off-balance-sheet items is crucial to understanding the risk profile and financial position of the institution. However, the nature of these items and their implications can differ significantly between the two types of banks.

Commercial Banks
For commercial banks, the on-balance-sheet items include traditional banking assets and liabilities such as loans, deposits, securities, and equity capital. These are straightforward items that directly affect the bank's financial statements and are subject to regulatory capital requirements.

Off-balance-sheet items for commercial banks, on the other hand, are not directly reflected on the balance sheet. These might include items like guarantees, letters of credit, derivatives contracts, or securitized loans. These are contingent liabilities or assets that could potentially become real liabilities or assets depending on certain events or conditions. They're used for managing risk and to potentially avoid regulatory capital requirements. However, these items can expose the bank to significant risks, as was evident during the 2008 financial crisis when off-balance-sheet securitized mortgages led to substantial losses for many banks.

Central Banks
Central banks operate differently from commercial banks. Their primary roles include managing the country's money supply, setting interest rates, and ensuring the stability of the financial system.

On-balance-sheet items for central banks typically include foreign exchange reserves, gold reserves, domestic government securities, and loans to commercial banks. These assets are used to implement monetary policy and manage the country's foreign exchange rate.

Off-balance-sheet items for central banks could include commitments to provide liquidity to commercial banks or to intervene in foreign exchange markets. These are not immediate liabilities, but they represent potential future cash outflows depending on the circumstances.

It's crucial to note that the distinction between on-balance-sheet and off-balance-sheet for central banks is not about avoiding regulatory capital requirements (as it might be for commercial banks), since central banks don't face such requirements. Instead, it's about managing risk and implementing monetary policy.

It's important to note 

that converting off-balance funds into on-balance funds can have implications for a bank's capital and liquidity requirements, as well as its overall risk profile. Therefore, banks should carefully consider the potential benefits and risks of each approach before deciding which one to use. Additionally, banks should ensure that they comply with regulatory requirements for on-balance sheet assets.

Types of Off-Balance Sources in Central Banks

1. Approved Off-Balance Sheet Commitments

These commitments are essentially contingent assets or liabilities that the central bank’s board has reviewed and authorized for potential use. Activating these funds involves several steps:

a. Recognition on Balance Sheet:

  • Authorization: The central bank’s board formally authorizes the movement of these commitments from off-balance sheet to on-balance sheet status.
  • Accounting Entry: The central bank records the commitments as actual assets or liabilities on its balance sheet. For example, if it’s a loan guarantee, the potential future payment obligation might be recognized as a liability.
  • Fund Allocation: These commitments might include loan guarantees, credit facilities, or other financial instruments that, once moved on-balance sheet, can be actively utilized for monetary policy operations.

b. Monetary Policy Operations:

  • Open Market Operations: The central bank might use these newly recognized assets to conduct open market operations, buying or selling government securities to influence liquidity and interest rates.
  • Lending Facilities: Approved commitments can be used to back lending facilities, providing liquidity to commercial banks through discount windows or other lending mechanisms.

c. Economic Impact:

  • By bringing these commitments on-balance sheet, the central bank can directly influence the money supply, augmenting its capacity to stabilize the economy.

2. Unapproved Off-Balance Sheet Items

These items have not yet received formal approval from the central bank’s board, meaning they are not immediately available for use. However, their potential activation can be pursued through specific procedures:

a. Review and Approval Process:

  • Proposal Submission: Relevant departments within the central bank submit a detailed proposal to the board, outlining the nature, purpose, and expected impact of these items.
  • Risk Assessment: A thorough risk assessment and due diligence are conducted to evaluate the potential financial and economic impacts.
  • Board Approval: The board deliberates and, if convinced of the strategic value, grants approval, thus converting these items into approved commitments.

b. Activation:

  • Once approved, the process mirrors that of the approved commitments. The items are moved onto the balance sheet, recognized appropriately, and utilized in monetary policy operations.

3. Dormant Off-Balance Sheet Accounts

Dormant accounts are those that were once active but have become inactive. They often remain off-balance sheet due to historical reasons. Reactivating these funds involves a distinct process:

a. Re-evaluation and Reactivation:

  • Audit and Evaluation: The central bank conducts an audit to determine the current status and potential utility of these dormant accounts. This includes assessing whether the reasons for dormancy still apply.
  • Board Approval: A proposal to reactivate these accounts is submitted to the board, similar to the process for unapproved items. The board evaluates the proposal and, if it aligns with current monetary policy objectives, grants approval.

b. Accounting Treatment:

  • Reclassification: Upon approval, the dormant accounts are reclassified and brought onto the balance sheet as active assets or liabilities.
  • Capital Injection: If necessary, the central bank may inject capital to revitalize these accounts, making them operationally viable.

c. Utilization in Policy:

  • Monetary Tools: Reactivated accounts can be used to bolster the central bank’s toolkit for monetary policy. For example, they might support new credit facilities or be leveraged in open market operations to manage liquidity.

Strategic Considerations

a. Risk Management:

  • Credit Risk: Activating these off-balance sheet items necessitates stringent credit risk assessments to avoid potential financial instability.
  • Market Risk: The central bank must consider market reactions to such activations, ensuring that the measures do not induce volatility.

b. Transparency and Communication:

  • Public Disclosure: Transparent communication regarding the activation of these funds is critical to maintaining market confidence.
  • Stakeholder Engagement: Engaging with commercial banks and other financial institutions ensures a smooth implementation of these monetary tools.

Conversion of off-balance/ledger currency into on-balance/ledger currency

The rigorous Central Counterparty (CCP) Currency Creation Process is employed for entities or governments to facilitate the conversion of off-balance sheet currency into on-balance sheet currency on Central Bank Level.

Currency creation transpires through an extension of the balance sheet: assets, primarily in the form of government bonds, are added to the asset side of the balance sheet, while reserves are recorded on the liability side. The central bank generates new reserves virtually "out of thin air," thereby acquiring the corresponding assets.

Off-balance sheet liabilities can be leveraged in a similar manner for corporations or other entities. This process involves converting off-balance sheet commitments or contingent liabilities into on-balance sheet currency by recognizing them as actual liabilities on the entity's financial statements. By doing so, organizations can effectively manage their financial risks, enhance transparency, and ensure compliance with accounting standards and regulatory requirements.

In this context, the CCP Currency Creation Process serves as a robust mechanism to support the conversion of off-balance sheet currency into on-balance sheet currency for a diverse range of entities, including governments and corporations. 

By implementing this process, these organizations can ensure accurate representation of their financial positions, safeguard the stability of the financial system, and foster long-term economic growth.

The money creation process is the process by which new money is added to an economy. In most modern economies, this process is largely carried out by central banks and commercial banks.

Central banks, such as the Federal Reserve in the United States or the European Central Bank, are responsible for regulating the supply of money in an economy and ensuring monetary stability. One way that central banks create new money is through the purchase of assets, such as government bonds. When a central bank buys a bond from a commercial bank, it pays for the bond with a deposit at the central bank. This deposit is effectively new money that has been added to the economy.

Commercial banks also play a role in the money creation process. When a commercial bank makes a loan, it creates new money by crediting the borrower's account with the loan amount. This new money enters circulation when the borrower spends it.

The money creation process can also occur through the expansion of bank reserves. Bank reserves are the funds that a bank holds in reserve at the central bank and are required by law to ensure the stability of the financial system. When a central bank increases the amount of reserves that a commercial bank is required to hold, it effectively creates new money that can be loaned out to borrowers.

Overall, the money creation process is an important part of the functioning of a modern economy. By regulating the supply of money and ensuring monetary stability, central banks and commercial banks play a critical role in supporting economic growth and stability.

Converting Off- to On-Balance Funds

Already existing off-balance Funds

Off-balance funds from the Central Bank refer to funds that are not included on a bank's balance sheet. These funds may be held in accounts outside of the bank's normal operating accounts, such as in a special purpose vehicle (SPV), or may be invested in certain financial instruments that do not qualify as on-balance sheet assets.

Converting off-balance funds from the CB into on-balance funds can be done in several ways, depending on the specific circumstances of the funds and the bank involved. Here are some possible approaches:

  • Securitization: If the off-balance funds consist of loans or other assets that can be securitized, the bank can create a securitization vehicle to issue bonds or other securities backed by those assets. These securities can then be sold to investors, bringing the off-balance funds onto the bank's balance sheet as on-balance assets.
  • Repurchase agreements: The bank can enter into repurchase agreements, or repos, with other financial institutions or investors. In a repo, the bank sells the off-balance funds to the counterparty with an agreement to buy them back at a later date. The funds are treated as collateral for the repo transaction and are therefore included on the bank's balance sheet.
  • Structured notes: The bank can issue structured notes that are linked to the performance of the off-balance funds. These notes are similar to bonds, but their value depends on the underlying assets rather than a fixed interest rate. The notes can be sold to investors, and the bank can use the proceeds to bring the off-balance funds onto its balance sheet.

Newly issued off-balance Funds

If the Central Bank creates new off-balance funds with the intention of eventually converting them into on-balance funds, the process for doing so would likely involve a combination of regulatory and accounting measures.

If the funds have been newly created by the central bank as off-balance funds, it may not be possible to convert them into on-balance funds in the same way as existing off-balance funds. This is because the newly created funds may not yet have any underlying assets that can be securitised, used as collateral in a repo, or linked to structured notes.

  • In this case, the bank may need to wait until the newly created funds have been invested in qualifying assets before they can be brought onto the bank's balance sheet. 

Alternatively, the bank may need to find a solution that allows the funds to be treated as on-balance-sheet assets

  • One possibility is that the CB could issue new bonds or other debt securities, which would be classified as off-balance funds. The CB could then use the proceeds from these securities to purchase eligible assets, such as government bonds or other securities that qualify as on-balance sheet assets. Once these assets have been acquired, the CB could then transfer them onto its balance sheet, effectively converting the off-balance funds into on-balance funds.
  • Another option is that the CB could use its off-balance funds to create special purpose vehicles (SPVs) or other similar entities, which could be used to hold eligible assets. 

The Complex Mechanisms of Money Creation: Central Banks, Commercial Banks, and Economic Ideologies

Money—the bills and coins used in transactions every day—does not just spring into existence spontaneously. The process of currency creation and management involves a complex interplay between central banks, commercial lending institutions, regulatory frameworks, economic ideologies, and monetary policy tools. This intricate balancing act aims to expand access to capital for economic growth while keeping inflationary risks in check. 

A. Key Central Bank Processes Driving Money Supply

Central banks have a number of potent but often misunderstood mechanisms to calibrate overall money supply in line with policy mandates. These help set the stage for commercial bank lending through reserves management, interest rates steering, and market interventions when needed. The constraints and impacts of these institutional choices also tie into long-running academic debates.

1. Flexible Bank Reserves Modulation

A key way that central banks shape the amount of funds commercial banks have available for lending is through open market operations (OMO)—the buying and selling of securities holdings to respectively increase or decrease banking system reserves. But they also have additional tools to alter reserve balances dynamically.

i. Steering Short-Term Rates Through Open Market Operations

The most powerful and flexible mechanism used actively by leading central banks like the U.S. Federal Reserve is open market operations. As explained by the Federal Reserve Bank of New York, this refers to central banks engaging in transactions to purchase or sell securities holdings, typically government bonds or bills in practice, to expand or contract the quantity of reserves in the banking system. 

This helps move a key benchmark interest rate—the target federal funds rate in the case of the Fed—to a level consistent with current monetary policy stances aiming to tighten or loosen credit conditions. When the Fed buys securities under expansionary policy, for instance, it credits reserves balances to commercial banks selling them. This expands their lending capacity, exerting downwards pressure on target short-term interbank lending rates. Additional lending also drives further money creation through the commercial banking system. Open market operations can thus flexibly calibrate overall money supply on an ongoing basis.

But it is an imperfect mechanism. As noted by Princeton economist Markus Brunnermeier and other researchers, interest rates are a blunt signaling instrument and face decreasing stimulus effects once rates approach the zero lower bound. This has led central banks to rely increasingly on large-scale assets purchase programs to provide additional monetary policy accommodation in recent decades.

ii. Quantitative Easing for Added Stimulus 

Quantitative easing or QE refers to central banks making large purchases of longer-dated, less liquid securities like government bonds, agency mortgage-backed securities or even corporate bonds to lower longer-term interest rates more broadly when short-term rates alone are deemed inadequate to support growth objectives. This is intended to incentivize lending, spending, and investments sensitive to longer-term rates like housing, thereby providing additional boosts to demand and economic activity during periods of stagnation.

But since longer-dated, riskier securities are less liquid, such programs expand central bank balance sheets much more substantially relative to the amount of stimulus generated compared to open market operations targeting short-term rates, as analyzed by monetary policy expert Vincent Reinhart. This can heighten risks of market distortions and inflation, spurring significant debate among economists about the appropriate scope, economic impacts, and risks of this mechanism which has now seen widespread adoption by major central banks in fighting economic crises over the last 15 years.

iii. Altering Reserve Requirements to Loosen Lending 

Besides open market operations and QE bond purchases to dynamically grow reserves balances, central banks can also simply loosen regulatory requirements for a more permanent effect since this frees up commercial banks' preexisting assets. Lowering or eliminating reserve requirements against certain deposit types allows financial institutions to lend out a greater portion of held customer funds.

According to studies by former Fed economist Antoine Martin, changes to requirements ratios have served at times as a useful additional tool to alter lending capacity and stimulate economic activity, complementing OMOs impact on managing level targeted by policymakers. The Federal Reserve now imposes no reserve requirements against transaction deposits and savings deposits, freeing up over $3 trillion in funds at sizable banks for potential lending after drops over recent years. Minimum ratios for deposits likely reduce deposit rates offered to consumers however, reflecting their partial costs to banks.

iv. Direct Lending as Liquidity Backstop

The Federal Reserve and many other central banks globally also have discount window lending programs allowing eligible banks access to direct central bank loans, against pledged collateral like government securities, loans or mortgages, to meet temporary liquidity needs. Costs are typically set above prevailing market rates to ensure borrowers rely primarily on private funding markets to discourage overuse. But importantly, this facility helps ensure solvent firms retain access to required reserves even under financial market stress, when liquidity shortages may otherwise curb lending activity and stymie growth.

According to New York Fed research, discount window borrowing patterns suggest underutilization due to bank stigma from opting into such emergency help programs when private markets typically suffice to fund operations. This likely indicates that direct loans are serving more as a market stability backstop rather than as a normal tool to ease policy per se in practice currently. Nonetheless, such programs can directly alter commercial lending capacity by shoring up specific institutions' balance sheets if ever warranted to contain liquidity shortfalls.

2. Adjusting Policy Rates to Steer Credit Conditions

Separate from directly controlling system reserves, monetary policymakers also use open communication on benchmark rate setting expectations to broadly influence credit conditions and the incentives of banks to expand lending relative to risks perceived across the economy. This provides a more indirect, signaling steering effect on money creation.

i. Benchmark Short-Term Rates as Key Signaling Tool  

The most important reference rate globally is the U.S. Fed Funds target range, currently set between 4.5-4.75% after rapid hikes over 2022 to contain inflation. As explained clearly by Minneapolis Fed president Neel Kashkari, major central banks provide clear forward guidance on target rate plans to shape expectations on the overall cost of credit over 6-18 month horizons, aiming to calibrate borrowing appetite and thereby aggregate demand growth to achieve mandated policy targets - whether inflation, output gaps or other aims set by statute.

As lending rates offered by commercial banks to consumers and businesses closely track the central bank's policy rate, raising or cutting benchmarks appreciably impacts broader credit conditions and willingness to take out loans across sectors. This gives monetary policymakers an indirect but still quite effective lever to influence commercial bank lending behavior and thereby money creation dynamics, separate from reserves adjustments.

ii. Quantitative Tightening to Reduce System Liquidity

To reverse the substantial balance sheet expansions under quantitative easing programs once the economy strengthens, central banks have to deliberately reduce excess liquidity pumped in over multi-year crisis interventions through bond runoff schemes dubbed quantitative tightening (QT). As detailed by Brookings Institution fellow Nellie Liang, this entails phasing out reinvestments as securities mature so excess reserves in the banking system decline gradually over time. QT also dampens lending capacity and credit availability more broadly as liquid assets shrink.

While QE and QT seem mechanically simple, their unprecedented scale could generate unpredictable market impacts and volatility spikes that destabilize commercial bank behavior more severely than intended. IMF research on QT risks flags from bond market selling pressure as portfolios rebalance and market making capacity shrinks. The counterargument suggests downplaying novel aspects since economic growth and inflation are key aggregates steered deliberately, not balance sheets per se. Nonetheless, deploying temporary QE then withdrawing liquidity remains an area with uncertain effects for commercial bank operations, despite increasing prevalence across central banks toolkit in recent decades.  

3. Market Interventions to Manage Economic Shocks

In times of financial instability or currency pressures abroad, central banks may conduct more extensive buying and selling operations as needed to restore orderly markets and prevent ripple effects into the real economy. But such interventions skew relative asset prices and carry unintended consequences too, provoking criticisms.

i. Short-Term Foreign Exchange Actions  

To relieve sudden pressures causing or exacerbating currency crashes, central banks can conduct direct foreign exchange intervention operations to counter disorderly, volatile declines. As explained by the Bank for International Settlements (BIS), this entails selling reserves of foreign currencies in sufficient size to slow or reverse falls, or at least signal policymaker concerns on excessive, destabilizing moves. Fx intervention aims to avoid panics and herd effects that overshoot economic fundamentals.

Research on such cases globally suggests short-term operations restraining misalignments can calm dysfunction and restore rational valuations, on occasion effectively. But economists like Princeton's Atish Rex Ghosh caution interventions risk encouraging future speculation by absorbing risk of losses. This generates moral hazard. Temporary fx action also drains reserves without addressing root economic issues. If concerns are structural, countries may need to ultimately realign currency values, accept higher interest rates or enact deeper reforms.

ii. Asset Purchases to Preserve Market Functioning

In acute crises, the economic threat horizon extends beyond currency instability as all funding markets can seize up with risks of severe fallout into households and businesses. As seen in 2008 and again in March 2020 with Covid-19 shocks, even government bond markets can face evaporating demand, destabilizing core pricing relationships. Zurich professor Peter Kugler's analysis underlines how this generates deep uncertainty on relative values and risks that freezes lending across assets.  

Faced with threats of comprehensive financial meltdown, central banks like the Fed, ECB and Bank of England rapidly expanded existing QE programs to pledge open-ended purchases across bond markets essential for functioning economies. This aimed to serve as buyer-of-last-resort, restoring orderly trading mechanisms to preserve credit availability, in contrast with more selective fx intervention. The downside, however, was even larger expansion of balance sheets and associated risks. Total assets doubled for major central banks within months to nearly $20 trillion. While necessary to avoid depression, critics see mounting dangers of market addiction and question exit strategies.

Overall the presence of contingent interventions breeds wider moral hazard. But given limits preventing withdrawal, central banks continue targeting stability for vulnerable markets to secure economic recovery before attempting to restore normality. The over-reliance risks from distortionary measures remains worrying however with poor understanding of second-order effects on commercial bank operations.

B. Commercial Bank Lending Mechanisms

Within the wider central bank framework governing reserves and interest rates, commercial banks have their own core lending models enabling deposit creation and money expansion. Under fractional reserve systems, only a portion of deposited funds are kept as cash reserves while excess is lent to borrowers, spurring money multiplication. Risk considerations temper unchecked credit extension however.

1. The Power and Perils of Fractional Reserve Banking 

A pivotal yet commonly misunderstood fact about commercial banking systems is their practice of fractional reserve banking. This means banks only keep a fraction of received deposits on hand as cash reserves, lending out the majority to earn interest income from borrowers. But the act of lending new deposits itself triggers wider money creation by expanding purchasing power.

i. Money Multiplication from Fractional Reserves

The International Monetary Fund (IMF) helps illustrate through simple examples how fractional reserve banking enables money multiplication and credit creation. Assume an initial cash deposit of $100 dollars in Bank A. With a reserve requirement of 10%, it would keep $10 as reserves on hand but loan out the rest $90. The borrower spends this $90 on goods or services at a recipient who then deposits the payment into Bank B. After keeping 10% or $9 as reserves, Bank B can now lend $81 to another customer. As this process repeats with loans creating new deposits, a small portion of reserves supports expansion of far greater balances across the commercial banking ecosystem.

With a 10% ratio, the originally deposited $100 enables up to $900 in new loans. But with a 5% requirement, this could theoretically reach $1,900. By only keeping a fraction of deposited money as reserves rather than the full amounts, lending supported in the wider financial system via deposits exceeds actual reserves by a factor of 10 or more. Absent regulation, the incentives favor endlessly expanding cycles of lending, at least until borrowers default. This makes fractional reserves pivotal for money creation but also risky if left unchecked.

ii. Growing Recognition of Inherent Instability   

Many observers have pointed to the instability of fractional reserve systems due to reliance on depositor confidence and market liquidity to avoid mass withdrawals, given the low actual cash ratios. Famed economist John Maynard Keynes for instance explained its vulnerability simply during the early 20th century: "There is no escape from a 'run' except by the injection of money...the amount of the injection required is probably six or seven times the total amount of cash normally kept for such contingencies." This was borne out to dramatic effect in the Great Depression's 1933 bank runs climax. Similar dynamics plagued 2007's interbank market seizure up through emergency central bank relief measures.

Consequently, today's commercial banking models recognize inherent mismatches from short-term liabilities like deposits against riskier long-term lending assets on their books. Regulations now ensure asset quality standards, access to central bank backstops as last resort, and resolution mechanisms to manage potential failures of even very large global banks. But the basic tension persists between striving to lend out excess reserves to profit from implicit maturity risks taken versus maintaining adequate safeguards and cash buffers to guarantee pledges redeemable on demand.   

2. Liquidity Risks Contained Through New Safeguards 

While maturity mismatch issues are better appreciated today, liquidity risks remain in transforming short-dated funds into earning assets and loans. Interbank markets bridge this gap but faced seizure in 2008. New regulations aim to temper associated threats to money creation availability even amid market disruptions. 

i. Interbank Markets to Recycle Excess Reserves  

A key mechanism allowing banks to manage reserve balances dynamically is the interbank lending market. This short-term funding marketplace lets institutions with excess reserves provide deposits callable in less than six months to those facing temporary shortfalls from client withdrawals. While lending terms are typically under a month, overnight lending rates represent benchmark indicators of liquidity conditions banks operate amid. As the Bank of International Settlements (BIS) observes, elevated rates signal tightened funding access from perceived counterparty risks while lower rates suggest stable flows recycling reserves where needed unimpeded.

But as severe asset repricing in 2007 led to uncertainty over hidden risks, trust in the interbank system evaporated. The IMF described this breakdown as a “systemic sudden stop” in critical short-term funding markets many banks relied upon to bridge deposit fluctuations. As queues requesting reserves could no longer clear through the paralyzed network, a series of failures and forced mergers followed despite adequate capitalization otherwise. This underscored risks from structured products and necessity of liquidity buffers since market access could disappear abruptly.  

ii. New Regulatory Support Structures 

Given the economic carnage from frozen interbank channels, the Basel III accords established binding liquidity standards forcing banks to maintain adequate cash or high-quality assets to survive end-of-day cash outflows for 30 days based on historical patterns. This Liquidity Coverage Ratio (LCR) directly buffers banks against tight markets that previously amplified systemic shortages into bank distress. Alongside heightened capital cushions, the liquidity coverage requirements structurally reduce chances of repeats of 2008 seizures in money markets critical to financial system functioning.

Nonetheless, regulators walk a tightrope balance as noted by Bank of England's Jon Cunliffe. Excess regulation such as unduly high liquid asset mandates would impede profitable lending funded by short-dated deposits. Cunliffe argues resilience against external shocks must be weighed against preserving adequate credit availability and some inherent maturity transformation supporting money creation flows. But given economic stakes, most regulators err conservatively on limiting bank risks.

3. Loan-Deposit Expansion Cycle in Action

In practice, the actual lending process follows loan-deposit multiplication dynamics as modeled conceptually in fractional reserve illustrations. Individual loans create new deposits, fueling further lending capacity while controlled through risk management frameworks. 

i. Case Study of Money Creation from Mortgages

To illustrate actual lending sequences spurring money creation, consider a homebuyer named Jane financing an $800,000 house through a mortgage from Wells Fargo. The moment the loan is issued, $800,000 in new deposit money is created as payment is wired. To fund this, Wells Fargo draws on its working cash reserves from other depositors but expects to earn back that balance plus interest from Jane's subsequent monthly installments. So long as Jane keeps paying down principal, the bank expects to profit from the spread by indirectly leveraging its fractional reserves, without needing to use up $800,000 in preexisting assets.

However, this new loan deposit is not extinguished. The recipient of Jane's home purchase payment now deposits the $800,000 check in Citibank, where it functions as usable money for further transactions. After keeping the legally required 10% reserves, Citibank can now issue $720,000 in new loans, repeating the cycle of loan creation through the commercial banking system. In this real illustration, a single large home loan expanded money supply to a degree that only a 10% reserve rule permits, through the multiplier dynamics inherent in the loan-deposit system.

ii. Risk Evaluation Constraining Deposit Multiplication 

Of course, prudential risk considerations temper Approvals. Using underwriting criteria, Wells Fargo must have assessed Jane's income streams and existing liabilities to judge default probabilities before agreeing to finance such a sizable home loan obligation well beyond her initial deposit balance as a customer. Required credit scores, past payment history, debt-income ceilings and collateral valuations constrain the pace of loan creation from fractional reserves.

New capital regulations like Basel III also require larger base cushions tied to size of banks' aggregate risk-weighted assets, directly limiting lending opportunities. As the consulting firm McKinsey & Company notes, while financial institutions aim to maximize loan assets, they must sufficiently provision against inevitable defaults and set interest rates high enough to profit given risks and costs faced in borrowing from client deposits. Finding optimal strategies between aggressive money creation fueling wider economic output and prudent safeguards maintaining public trust is an inherent tension in commercial banking.

4. Securitization Extending Credit Reach and Risks

Moving beyond direct lending against fractional reserves, banks have also pioneered indirect loan funding structures that extend money creation scale and availability but add opaque entanglement risks seen dramatically in 2008.

i. Securitization Expanding Liquidity and Credit 

Chief among bank innovations expanding functional money claims beyond reserves held is securities issuance backed by expected repayment flows from consumer debts like mortgages, student loans, auto loans and credit card borrowing. Under securitization, packages of loans are funneled into structured investment vehicles (SIVs) or special purpose vehicles (SPVs) that sell tranched bonds backed by the underlying collateralized asset values to investors in global markets. This raises wholesale monies for further lending while freeing up bank capital for more fractional reserve creation.

Fees and Costs to take into Consideration

Providing a precise estimates for the costs associated with transitioning off-balance-sheet transactions to on-balance-sheet in the context of money creation and secured assets, per billion USD generated, entails navigating a multitude of variables specific to the transaction, the regulatory environment, and the nature of the assets involved and it is therefore impossible. Some of the fees and costs that should be taken into consideration are:

  1. Regulatory Capital Requirements: The Basel III framework requires banks to maintain a minimum capital adequacy ratio of 8%, of which 4.5% must be Tier 1 capital, with the rest being Tier 2 capital. For a billion USD in assets transitioned on-balance, assuming a 100% risk weight, banks would need to hold at least 80 million USD in regulatory capital. The actual cost would depend on the bank's cost of capital, which can vary widely but often ranges from 6% to 12% annually.
  2. Liquidity Requirements: The Liquidity Coverage Ratio (LCR) requires banks to hold an amount of high-quality liquid assets (HQLA) that can cover net cash outflows over a 30-day stress period. The Net Stable Funding Ratio (NSFR) requires a stable funding profile in relation to the composition of assets and off-balance-sheet activities. The cost here is the difference in yield between holding HQLAs (e.g., government bonds) versus employing the capital in higher-yield investments. This could range from 1% to 3% of the billion USD annually, or 10 million to 30 million USD.
  3. Transaction and Processing Costs: These costs include legal fees, due diligence, and administrative expenses. They are highly variable but can be estimated at 0.1% to 0.5% of the asset value, or 1 million to 5 million USD for a billion USD in assets.
  4. Impact on Financial Ratios and Operational Complexity: Quantifying these indirect costs requires assessing the broader impact on the bank's operations, market perception, and strategic flexibility. While a direct cost estimation is challenging without specific data, these factors could lead to increased costs of capital or operational inefficiencies that might indirectly cost millions of dollars annually.
  5. Opportunity Costs: The opportunity cost of capital locked in regulatory capital and liquidity positions instead of being deployed in higher-yielding ventures can be significant. Assuming an alternative investment yield of 8% to 15%, the opportunity cost could range from 80 million to 150 million USD annually per billion USD of assets moved on-balance.

The total cost of transitioning assets from off-balance to on-balance in the context of money creation, per billion USD, could realistically range from 91 million USD to 265 million USD annually, factoring in direct, indirect, and opportunity costs. These estimates are highly sensitive to the specific operational, regulatory, and market contexts of the financial institution, as well as to the prevailing economic conditions. Therefore, it's critical for institutions to conduct detailed analyses to understand the full implications of such strategic decisions.

If you want to discuss with us your specific needs regarding currency creation, please contact our director Isof Baco.