AQA A-level Economics: Banks, credit creation and financial regulation (7136) – Revision Notes

These notes condense sub-sections 4.2.4.2 and 4.2.4.4 of the AQA A-level Economics (7136) specification (3.2.4.2 and 3.2.4.4 on the AQA website). For full explanations and longer worked examples, read the study guide. Test yourself afterwards with the practice set.

Related pages: the AQA A-level Economics hub, the printable checklist, the aggregate demand and supply guide and the free 10-minute diagnostics. All banks, countries and figures are invented for illustration.

Key definitions

Term	Meaning
Commercial bank	Takes deposits and lends, mainly to households and firms; runs payments
Investment bank	Serves large clients: advice on takeovers, raising finance through shares and bonds, trading. Fee and trading income
Balance sheet	Assets = liabilities + capital
Asset	Something the bank owns or is owed (loans, bonds, cash)
Liability	Something the bank owes (deposits, borrowing)
Capital	Owners’ stake. The cushion that absorbs losses
Liquidity	Ability to meet payments when due
Profitability	Earning more on assets than it costs to fund them
Security	Low risk of loss on assets and of failure
Credit creation	New deposits made when banks lend
Systemic risk	Risk that trouble at one institution spreads and threatens the whole system
Moral hazard	Riskier behaviour when another party carries part of the downside

Functions of a commercial bank

• Accept deposits and provide a safe place for savings.
• Lend: overdrafts, loans, mortgages.
• Operate payments between customers.
• Create credit.
• Maturity transformation: turn short-term deposits into long-term loans.

Balance sheet reminder

Bank L (invented, £m): liquid assets 30, loans 170, so assets are 200. Deposits are 176. Capital is the balancing item: 200 − 176 = 24.

• Losses reduce assets, and the whole loss falls on capital first.
• Capital of 24 is wiped out if assets fall by 24, which is 24 ÷ 200 = 12% of assets.
• Loans are assets. Deposits are liabilities. Never swap them.

Objectives and conflicts

Pair	Why they conflict
Liquidity v profitability	Cash and quick-to-sell assets earn little. Long loans earn more but cannot be turned into cash quickly
Security v profitability	Safe borrowers pay low interest. Risky borrowers pay more but may default
Liquidity v security	Less often a conflict. Holding more liquid assets usually helps both

Bank managers balance these by holding a spread of assets: cash, short-term lending, bonds, then loans.

Asset ladder for a commercial bank (from most liquid and lowest return to least liquid and highest return): cash and central bank balances, short-term lending to other banks, government bonds, then loans to households and firms. Moving down the ladder raises expected profit and lowers liquidity. Riskier borrowers sit at the bottom.

Worked reminder. Bank L moves 20 from loans yielding 5% into bonds yielding 2%. Income falls by 20 × (0.05 − 0.02) = 0.6. Its liquidity rises. Its profitability falls, and so does its exposure to defaults.

Credit creation: method in steps

1. A new deposit arrives at a bank.
2. The bank keeps part of it liquid and lends the rest.
3. The loan creates a deposit in the borrower’s account.
4. The borrower spends. The payee’s bank receives a new deposit.
5. That bank keeps part and lends the rest. Repeat, each round smaller.

Limits: demand for loans, the liquidity banks choose or are required to hold, capital, leakage into cash, and policy. The credit multiplier is not calculated in the AQA specification, so learn the chain, not a formula.

Combined banks

Banks that run both retail and investment activity are bigger and more complex.

• Risk: trading losses may threaten ordinary depositors, and the state may feel it must rescue the bank (systemic risk, moral hazard).
• Benefit: income from different activities is diversified.

Why combined banks worry regulators. The activities share one balance sheet and one brand. A loss in trading can spread to the deposit-taking side, so ordinary savers and the payment system are exposed. This is why a combined bank can be seen as too important to fail.

UK regulation

Body	Remember it as
Bank of England	Responsible for financial stability; houses the PRA and FPC
PRA	Safety of individual firms (banks, insurers). Capital and liquidity standards
FPC	Risks to the whole system. Acts to reduce systemic risk
FCA	Conduct: fair treatment of customers and honest markets

An in-depth knowledge of these bodies is not expected. Link each to financial stability.

Why banks fail

	Illiquid	Insolvent
Problem	Cannot meet payments now	Assets worth less than liabilities
Cause	Run, short-term funding withdrawn	Losses larger than capital
Link	Borrowing short, lending long	Risky lending, thin capital

Reminder. Bank L has liquid assets of 30. Depositors withdraw 20% of the 176 deposits: 0.20 × 176 = 35.2. The shortfall is 5.2. Bank L must sell loans, probably at a discount. A run can start from rumour alone and then become real.

Ratios. A liquidity ratio compares liquid assets with short-term liabilities. A capital ratio compares capital with assets. Higher ratios make failure less likely. They also reduce profit and lending. Neither is calculated in the specification.

Moral hazard: reminder

A bank can take a 50% chance of a gain of 8 or a 50% chance of a loss of 10. Expected value without a rescue: 0.5 × 8 + 0.5 × (−10) = −1. The bank would not take it. If a rescue covers losses, the bank’s expected value is 0.5 × 8 = 4, so it takes the gamble. The expected cost to the rescuer is 0.5 × 10 = 5. The bank gains, society pays.

Systemic risk and the real economy

Chain: bank losses → lower capital and confidence → credit crunch → lower investment and consumption → lower aggregate demand → lower output and higher unemployment → more loan defaults → weaker banks.

For evaluation: strength of bank capital, speed of regulatory and government response, alternative sources of finance, and the return of confidence.

Structure for a banking evaluation answer

1. Define the key term (for example, systemic risk).
2. Give a chain of reasoning, with each link explained: cause, bank balance sheet, lending, spending, output.
3. Use the data in the question. Quote figures and show a short calculation if asked.
4. Give a counterpoint: cost of regulation, diversification, strong capital, fast rescue.
5. Judge: which factor matters most, and under what conditions?

Must-know distinctions

• Commercial v investment bank.
• Liquidity v capital: liquidity meets payments, capital absorbs losses.
• Illiquid v insolvent.
• PRA (firms) v FPC (system) v FCA (conduct).
• Systemic risk v moral hazard: one is about contagion, the other about incentives.

Quick self-test

1. State one difference between a commercial and an investment bank.
2. A bank has assets of 90 and liabilities (excluding capital) of 78. What is its capital?
3. The bank in question 2 suffers a loss of 15 on its loans. What happens to its capital?
4. Explain why borrowing short and lending long is risky.
5. Which body monitors risks to the financial system as a whole?
6. A bank lent 20 to another bank, which fails and repays 55p in the pound. What is the loss?
7. Define moral hazard in banking.
8. Lending to firms falls by 5, the multiplier is 2 and GDP is 250. Calculate the percentage fall in aggregate demand.
9. Give two limits on credit creation.
10. Why might higher capital requirements reduce lending?

Answers

1. A commercial bank takes deposits and lends to households and firms. An investment bank advises large clients and trades or raises finance for them.
2. 90 − 78 = 12.
3. Capital of 12 is wiped out and the bank is 3 short (12 − 15 = −3). It is insolvent.
4. Deposits can be withdrawn quickly, but long loans cannot be recalled or sold quickly without loss. A run can leave it unable to pay.
5. The Financial Policy Committee.
6. 20 × 0.45 = 9.
7. Taking more risk because others (depositors, taxpayers) bear part of the cost of failure.
8. Fall in aggregate demand = 5 × 2 = 10. 10 ÷ 250 = 4%.
9. Any two from: demand for loans, liquidity needs, capital, leakage into cash, regulation.
10. Each loan needs capital behind it, so banks with fixed capital can support fewer loans, or must raise lending rates.

Where marks are usually lost

• Writing “the bank loses money” without saying who bears the loss first: capital.
• Mixing up liquidity and capital.
• Describing credit creation as banks lending out the same cash twice, instead of lending creating new deposits.
• Using real statistics from memory instead of reasoning from the data in the question.
• Listing regulators without saying what each does for stability.
• Stopping at “banks fail” without a chain to the real economy.
• Giving one-sided answers. Add a counterpoint, such as the cost of tighter regulation.

Official syllabus

AQA, AS and A-level Economics specification (7135 and 7136), version 1.3, 29 June 2022, sections 4.2.4.2 and 4.2.4.4.