Credit Creation By Commercial Banks
Question : What is Credit creation ? Explain the process of credit creation by Banks.
Credit Creation :
Credit creation is a process where a bank uses a part of its customers’ deposits to loans to other individuals and businesses. This results in more money created in economy.
Credit creation is the expansion of deposits. Banks can expand their demand deposits as a multiple of their cash reserves because demand deposits serves as the principal medium of exchange. Credit creation separates a bank from other financial institution.
Demand deposits are an important constituent of money supply and the expansion of demand deposits means the expansion of money supply.
A bank keeps a certain part of its deposits as a minimum reserve to meet the demands of its depositors and lends out the remaining to earn income. The loan is credited to the current account of the borrower. Every bank loan creates an equivalent deposit in the bank. Therefore, credit creation means expansion of bank deposits.
The two main aspects of credit creation are:
1. Liquidity:
The bank must pay cash to its depositors when they practice their entitlement to demand cash against their deposits.
2. Profitability :
Banks are profit driven enterprises. Therefore, a bank must grant loans in a manner which earns higher interest than what it pays on its deposits.
The bank’s credit creation process is based on the assumption that during any time interval, only a fraction of its customers genuinely need cash. Also, the bank assumes that all its customers would not turn up demanding cash against their deposits at one point in time.
Basic Concepts of Credit Creation:
1. Bank as a business institution :
Bank is a business institution which tries to maximise profit through loans and advances from the deposits.
2. Bank Deposits:
Credit creation depends on two type of deposits – Primary and Secondary deposits.
a. Primary deposits:
Primary deposits are those which people deposit with banks. Banks play a passive role in creation of such deposits as it is the decision of the customer which determines how much cash would be deposited by them in bank. Primary deposits do not make any change in total money supply in the economy.
b. Secondary deposits or Derivative deposits :
These deposits are generated when the banks lend or grant loans and instead of giving cash to the borrower, create an account on the name of borrowers. Every loan creates a deposit. The creation of derivative deposit means the creation of credit. These deposits add to the existing supply of money.
Banks are able to grant loans by an amount which is many time more than the cash they held in terms of primary deposits.
3. Cash Reserve Ratio (CRR) :
Cash reserve ratio is a certain fraction or percentage of total deposit which is kept by the bank to meet the day to day requirement is called cash reserve ratio. The remaining excess deposits are used to lend or advancing loans.
In other words, “Cash reserve ratio is a percentage or fraction of total deposit, which the banks must hold in cash reserve for meeting the depositors demand for cash.”
4. Excess Reserve:
The reserve over and above the cash reserves are the excess reserve. These reserves are used for loans and credit creation.
5. Credit Multiplier or deposit Multiplier:
Credit multiplier or deposit multiplier is the reciprocal of the deposits. It is defined as :
K = 1/RR
Where, K = deposit multiplier
RR = the ratio of cash reserve to deposit
If the value of RR is 20% of total deposit then deposit multiplier will be
K = 1/ RR = 1/ 20%
K = 100 / 20
K = 5
It means that if the bank keeps 20% of its total deposit as cash reserve and rest money is to lend then the credit multiplies five time.
In the process of multiple credit creation, the total amount of derivative deposits that a bank creates is a multiple of the initial cash reserves.
Process of Credit Creation:
Question: How do commercial banks create credit ? Explain with the help of example.
Credit Creation:
Credit creation is the expansion of deposits. Commercial banks creates money in the form of deposit money. Banks can create money by creating bank deposit and can reduce money by reducing bank deposit.
Let us take a numeric example:
|
Stage |
Banks or Ro |
Deposites (Rs) |
Cash Reserve (Rs) |
Loans (Rs) |
|
1. |
Bank of Baroda |
1000 |
200 |
800 |
|
2. |
Canara Bank |
800 |
160 |
640 |
|
3. |
ICICI Bank |
640 |
128 |
512 |
|
4. |
– |
– |
– |
– |
|
|
Total |
5000 |
1000 |
4000 |
1. Suppose there is multiple banking system.
2. Suppose the minimum legal CRR is 20%.
3. Excess over 20% cash reserve is used for advancing loans.
4. Suppose Bank of Baroda receives a cash deposit!of Rs 1000.
5. It is assumed that the amount of loan drawn by one bank will be transferred fully by every subsequent bank.
Explanation :
- Round 1 or First Round:
Suppose a customer deposits Rs 1000 in Bank of Baroda. BOB is required to keep 20% of its deposit as cash reserve and remaining for advancing loans.
Bank keeps = 20% of 1000
= (20/ 100) × 1000
= 200
Money for advancing loans = 1000 – 200
= 800
Therefore, Rs 800 is given to another customer by opening an account in his name.
- Round 2 or Second Round:
The borrower buys things and make a cheque payment of Rs 800 from BOB. The trader receiving the cheque has an account with Canara Bank so he deposits Rs 800 with Canara Bank. Now Canara Bank keeps 20% of 800 ( = Rs 160) as cash reserve and the excess reserve of Rs 640 (= 800 – 160) lends to some businessman opening an account in his name.
- Round 3 or Third Round:
The business man uses this Rs 640 in making purchase through a cheque drawn on Canara Bank. The seller has his account with ICICI Bank, he will deposit this cheque of Rs 640 with ICICI Bank.
ICICI Bank will keep a cash reserve of Rs 128 (= 20% of Rs 640) and extends a loan of Rs 512 (= 640 – 128) to some other client.
Thus, an initial deposit of Rs 1000 with BOB has resulted in a creation of deposits by three other banks amounting Rs 2952 (= 1000 + 800 + 640 + 512 ) and the process of credit creation is still go on.
The amount of credit created by every successive bank is decreasing continuously.
This process will end when the deposit received by a particular bank is too small to generate any fresh loans.
The number of times by which the credit is created from initial deposit is referred to as money multiplier or credit multiplier (K). It is the reciprocal of CRR.
K = 1/ RR
= (1/20% )
= 5
Total credit created = ( 1/ RR) × ∆D
Where, ∆D = initial deposit
Credit created = (1/ 20% ) × 1000
= (100 / 20) × 1000
= 5000
Limitations of Credit Creation:
The limitations of credit creation are as follows :
1. Total Amount of Cash Reserve:
Here the cash reserve means total amount of cash available in the economy. Higher the cash available with the people more will be the primary deposits which people make with commercial banks. Thus, the commercial banks will have more power to create credit.
However, the amount of cash to be held by commercial banks is controlled by the central bank.
The central bank may expand or contract cash in commercial banks by purchasing or selling government securities.
Moreover, the credit creation capacity depends on the rate of increase or decrease in CRR by the central bank.
2. Cash Reserve Ratio (CRR) :
The power of commercial banks to create credit depends on the cash reserve requirements. If the central bank increase the CRR, then banks are required to maintain larger proportion of their total deposit as reserve and the surplus with which to create credit declines.
On the other hand, if CRR is reduced, banks are required to maintain lesser proportion of deposits as cash reserve with central bank, they can create more credit now.
3. Banking Habits of People :
If the banking habits of people are well developed and their faith in banking system is strong, then majority of transactions in the economy are carried through banks using banking instruments. As the cash transaction are less the withdrawals from bank deposits are also less. The banks are required to maintain small cash reserves with them and larger surplus is available to create credit.
4. Nature of Securities Offered :
Banks lend loans against collateral securities. Hence availability of such securities will also determine the volume of credit created in the economy. Share and stocks, buildings, life Insurance policy etc are used as collateral securities.
More liquid the security, more acceptable to bank. In the absence of these credit creation is hampered.
5. Monetary Policy of Central Bank:
The credit creation power of commercial bank is limited by the credit control policy of the central bank.
If the central bank adopts ‘Dear Money’ policy, credit creation by commercial banks will decrease. While if it follows expansionary monetary policy, credit creation will increase.
6. Leakage:
If the banks are unwilling to utilise their surplus funds for granting loans, then the economy is headed towards recession.
If the public withdraws cash and holds it with themselves, then it reduces the banks’ power to create credit.
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