Credit Creation by Commercial Banks Handouts

Credit Creation by Commercial Banks and It’s Limitations
A central bank is the primary source of money supply in an economy through circulation of
currency. It ensures the availability of currency for meeting the transaction needs of an economy
and facilitating various economic activities, such as production, distribution, and consumption.
However, for this purpose, the central bank needs to depend upon the reserves of commercial
banks. These reserves of commercial banks are the secondary source of money supply in an
economy. The most important function of a commercial bank is the creation of credit. Therefore,
money supplied by commercial banks is called credit money. Commercial banks create credit by
advancing loans and purchasing securities. They lend money to individuals and businesses out of
deposits accepted from the public. However, commercial banks cannot use the entire amount of
public deposits for lending purposes. They are required to keep a certain amount as reserve with
the central bank for serving the cash requirements of depositors. After keeping the required amount
of reserves, commercial banks can lend the remaining portion of public deposits. According to
Benham’s, “a bank may receive interest simply by permitting customers to overdraw their accounts
or by purchasing securities and paying for them with its own cheques, thus increasing the total
bank deposits.”
The two most important aspects of credit creation are:
1. Liquidity – The bank must pay cash to its depositors when they exercise their right 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
• Bank as a business institution – Bank is a business institution which tries to maximize profits
through loans and advances from the deposits.
• Bank Deposits – Bank deposits form the basis for credit creation and are of two types:
o Primary Deposits – A bank accepts cash from the customer and opens a deposit in his
name. This is a primary deposit. This does not mean credit creation. These deposits simply
convert currency money into deposit money. However, these deposits form the basis for
the creation of credit.
o Secondary or Derivative Deposits – A bank grants loans and advances and instead of
giving cash to the borrower, opens a deposit account in his name. This is the secondary or
derivative deposit. Every loan crates a deposit. The creation of a derivative deposit means
the creation of credit.
• Cash Reserve Ratio (CRR) – Banks know that all depositors will not withdraw all deposits
at the same time. Therefore, they keep a fraction of the total deposits for meeting the cash
demand of the depositors and lend the remaining excess deposits. CRR is the percentage of
total deposits which the banks must hold in cash reserves for meeting the depositors’
demand for cash.
• Excess Reserves – The reserves over and above the cash reserves are the excess reserves.
These reserves are used for loans and credit creation.
• Credit Multiplier – Given a certain amount of cash, a bank can create multiple times credit.
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.
Credit creation by a single bank

There are two ways of analyzing the credit creation process:
a. Credit creation by a single bank
b. Credit creation by the banking system as a whole

In a single bank system, one bank operates all the cash deposits and cheques. The process of creating
credit is explained with the hypothetical example below:
Let’s assume that the bank requires to maintain a CRR of 20 percent.

• If a person (person A) deposits 1,000 rupees with the bank, then the bank keeps only 200 rupees
in the cash reserve and lends the remaining 800 to another person (person B). They open a
credit account in the borrower’s name for the same.
• Similarly, the bank keeps 20 percent of Rs. 800 (i.e. Rs. 160) and advances the remaining Rs.
640 to person C.
• Further, the bank keeps 20 percent of Rs. 640 (i.e. Rs. 128) and advances the remaining Rs.
512 to person D.
This process continues until the initial primary deposit of Rs. 1,000 and the initial additional reserves
of Rs. 800 lead to additional or derivative deposits of Rs. 4,000 (800+640+512+….).
Adding the initial deposits, we get total deposits of Rs. 5,000. In this case, the credit multiplier is 5
(reciprocal of the CRR) and the credit creation is five times the initial excess reserves of Rs. 800.
Some of the limitations of credit creation by commercial banks are shown in Figure-3:
The limitations of credit creation process (as shown in Figure-3) are explained as follows:
ADVERTISEMENTS:
(a) Amount of Cash:

Affects the creation of credit by commercial banks. Higher the cash of commercial banks in the
form of public deposits, more will be the credit creation. 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.
(b) CRR:
ADVERTISEMENTS:
Refers to reserve ratio of cash that need to be kept with the central bank by commercial banks. The
main purpose of keeping this reserve is to fulfill the transactions needs of depositors and to ensure
safety and liquidity of commercial banks. In case the ratio falls, the credit creation would be more
and vice versa.
(c) Leakages:
Imply the outflow of cash. The credit creation process may suffer from leakages of cash.
The different types of leakages are discussed as follows:

ADVERTISEMENTS:
(i) Excess Reserves:

Takes place generally when the economy is moving towards recession. In such a case, banks may
decide to maintain reserves instead of utilizing funds for lending. Therefore, in such situations,
credit created by commercial banks would be small as a large amount of cash is resented.
(ii) Currency Drains:

Imply that the public does not deposit all the cash with it. The customers may hold the cash with
them which affects the credit creation by banks. Thus, the capacity of banks to create credit
reduces.
(d) Availability of Borrowers:

Affects the credit creation by banks. The credit is created by lending money in form of loans to
the borrowers. There will be no credit creation if there are no borrowers.
(e) Availability of Securities:

Refers to securities against which banks grant loan. Thus, availability of securities is necessary for
granting loan otherwise credit creation will not occur. According to Crowther, “the bank does not
create money out of thin air; it transmutes other forms of wealth into money.”
(f) Business Conditions:

Imply that credit creation is influenced by cyclical nature of an economy. For example, credit
creation would be small when the economy enters into the depression phase. This is because in
depression phase, businessmen do not prefer to invest in new projects. In the other hand, in
prosperity phase, businessmen approach banks for loans, which lead to credit creation.
In spite of its limitations, we can conclude that credit creation by commercial banks is a significant
source for generating income.
The essential conditions for creation of credit are as follows:
a. Accepting the fresh deposits from public
b. Willingness of banks to lend money
c. Willingness of borrowers to borrow.

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Credit Creation by Commercial Banks and It’s Limitations

The two most important aspects of credit creation are:

Basic Concepts of Credit Creation

Credit creation by a single bank

a. Credit creation by a single bank

b. Credit creation by the banking system as a whole

Let’s assume that the bank requires to maintain a CRR of 20 percent.

(a) Amount of Cash:

The different types of leakages are discussed as follows:

(i) Excess Reserves:

(ii) Currency Drains:

(d) Availability of Borrowers:

(e) Availability of Securities:

(f) Business Conditions:

b. Willingness of banks to lend money

c. Willingness of borrowers to borrow.

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