An Introduction to Islamic Finance: Theory and Practice

140 AN INTRODUCTION TO ISLAMIC FINANCE

as a deposit in Bank 2. The process of money creation through the credit
multiplier continues until the initial amount of $100 would have been mul-
tiplied by 10 to become $1,000. The credit multiplier is thus defi ned as the
inverse of the reserve - requirement ratio.
Two traditional sources of instability can be observed. First, assume a
depositor at Bank 1 writes a check for $100 to a benefi ciary whose bank
is Bank 3, and then Bank 1 fi nds it diffi cult to make the payment of $100
and is caught with insuffi cient funds. If depositors at Banks 1 and 2 simul-
taneously exercise their drawing rights and write checks to a benefi ciary
at Bank 3, for amounts of $100 and $90, respectively, both Banks 1 and 2
will be caught short of funds. Money creation at deposit banks leads, there-
fore, to an un - backed expansion of credit, which exceeds real savings in the

Bank 1 - Balance Sheet

Assets

Reserves = $10

Loans/Securities = $90

Liabilities

Deposits = $100

Bank 2 - Balance Sheet

Assets

Reserves = $9

Loans/Securities = $81

Liabilities

Deposits = $90

Bank 3 - Balance Sheet

Assets

Reserves = $8.1

Loans/Securities = $72.9

Liabilities

Deposits = $81

Banking System-Balance Sheet

Assets

Reserves = $100

Loans/Securities = $900

Liabilities

Deposits = $1000

To Bank 4 to Bank n

FIGURE 7.1 The credit multiplier process