Hello Dear Friends, Welcome to KhanStudy.in. In today’s article we are going to know the process of credit creation by commercial banks. So let’s discuss in details.
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Explain the process of Credit Creation by Commercial Banks
Credit creation is one of the most important function of commercial bank. Credit creation refers to the unique power of the banks to multiplied loans to advanced and hence deposits. As minimum reserve for meeting the demand of the depositors and lends out the remaining excess reserve to earn income.
The bank loan is not paid to directly to the borrowers but its not only created in this account. Every bank loan creates and equivalent deposits in the bank. Thus credit creation means multiplied expansion bank deposits.
Assumption of Credit Creation by Commercial Banks
The process of credit creation by commercial banks can be analysed into three ways –
- All banks are one unit,
- Credit creation by a single bank and
- Credit creation by the single banking system as a whole. But in our discussion have discussed the process of credit by a single bank. As for example –
Suppose ‘A’ person deposits Rs.1000 with a bank. The bank keep reserve only 20% of the entire cash to meet the day cash demand. Thus keeping Rs.20%, the bank loans. The remaining Rs.800 to person ‘B’ by opening a credit amount in his name.
Again keeping 20% of Rs.800 (160) the bank advances the remaining Rs.640 to person ‘C’ and soon. This process will continue till the initial primary deposits and the initial excess reserves of Rs.800 leads additional deposits of Rs.4000 (800+640+512+…). By adding up all the deposits (Primary derivative) we get total deposits of Rs.5000.
Here, credit multiplied is 5 and the credit creation is 5 times, the initial excess reserve. The process of credit creation in a single bank system can be shown with the help of the following table –
| Rounds | Primary Deposits | Cash Reserve Ratio 20% | Total Credit Creation (r) |
| Person – A | Rs.1000 | Rs.200 | Rs.800 |
| Person – B | Rs.800 | Rs.160 | Rs.640 |
| Person – C | Rs.640 | Rs.128 | Rs.512 |
| Person – D | Rs.512 | Rs.102 | Rs.410 |
| Total – | Rs.5000 | Rs.1000 | Rs.4000 |
The table shows that on the basis of the cash reserve ratio of 20% and with initial primary deposits of Rs.1000, the bank creates derivative deposits of Rs.4000 and total amount deposits is Rs.5000. Thus the credit expansion (Rs.4000) is the times the initial excess reserve of Rs.800. Here the credit multiplied is 5. (The credit multiplier is the reciprocal of the cash reserve ratio, i.e. –
Credit multiplier (K) = 1/r
Where,
r = Cash Reserve Ratio.
The higher the cash reserve ratio the lower will be credit multiplier.
Limitations of Credit Creation by Commercial Banks
Theoretically the banking system can create unlimited amount of credit through expansion of deposits but in reality the powers of bank to create credit are subject to a number of limitation as explained below-
- Amount of cash – The extend of credit creation depends upon the amount of cash, with the banks, larger the amount of cash with the banking system greater will be the credit creation and vice-versa.
- Cash reserve ratio – The size of the credit multiplier is inversely related to the cash reserve ratio. The higher cash reserve ratio, the smaller will be the volume of credit creation and vice-versa.
- Availability of borrowers – Banks crate credit by means of loans and advances. Therefore, the extent of credit creation depends on the availability of borrowers. If there are no borrowers there will be no credit creation.
- Credit policy of other banks – If some banks decided not to utilize their full capacity for credit creation and keep large cash reserve, the credit creation in the country will be limit to that extant.
- Banking habits – If people prefers to make transaction through cash and not by cheques. The bank will be left with small cash and there will be lesser credit creation. Thus, credit creation depends on banking habits of the people.
- Business conditions – Credit creation is further limited by the nature of business condition. During depression when due to low profit expectation businessman does not come forward to borrow from banks credit creation very small and vice-versa.
- Nature of securities – The commercial banks always extend credit against securities. If sound and acceptable securities are not available to the commercial banks in a large measure, it is not possible for then a expand credit or deposit.
