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An adjustment credit is a short-term loan made between a nation’s central bank and a commercial bank. These loans help commercial banks maintain liquidity and are not meant to be a lifeline to bailout the bank, hence the short-term life of the credit. Most countries have a rather complex banking industry built on a series of loans made between banks. The central bank is responsible for setting fiscal or monetary policy that will provide a stable interest rate, ample money supply, and ability to loan money to individuals and investors.
A central bank primarily controls money supply through fractional-reserve banking and interest rates. Fractional-reserve banking allows commercial banks to lend a portion of the money they receive in customer deposits. For example, the central bank may require banks to only retain 10 percent of total deposited funds in the organization’s coffers. This means that commercial banks can lend 90 percent of deposited money to individuals and businesses. This can create a need for an adjustment credit if the bank experiences a large number of cash withdrawals. Rather than calling loans to pay out the withdrawals, the commercial bank generates a short-term loan with the central bank.
Another reason for an adjustment credit is when money supply is tight and the bank cannot generate sufficient capital from lending money. Central banks can set high interest rates, which will increase the cost of borrowing. While this crimps new loan origination, bank may have several outstanding loans that have depleted the organization’s cash supply. Because individuals and businesses cannot obtain new loans for financial purposes, they may withdraw money from their savings or checking accounts. A tight money supply means the commercial bank will most likely need an adjustment credit from the central bank to help supply cash for these withdrawals. This does not add to the money supply since the bank has already accounted for this money.
Short-terms loans using the adjustment credit process from a central bank may not result in immediate cash repayment. The commercial bank can use a promissory note, which gives the bank a longer amount of time to pay back the central bank. This provides the commercial bank enough time to collect principal and interest payments from previous loans to repay the adjustment credit. In classic economic theory, this form of a tight money supply and fractional-reserve banking system can create a bubble. When the promissory note comes due and the commercial bank cannot repay, the bank may need to call loans or find other capital sources to repay the credit, thus resulting in a house of cards falling apart.