Credit creation is the most significant function of the commercial banks. Commercial banks accept deposits and lend loans and advances. In this process they create two types of deposits, namely primary deposits and derivative or active deposits. The former refers to the cash deposited by a customer in a bank or deposit a cheque with the bank for collection. The banker merely accepts cash am converts it into a deposit. Hence, this is merely a passive role performed by the banks. These primary deposits do not add to the money stock in the economy. From their experience and observation the banks know that not all the customers will withdraw their deposits on any single day. Hence, after providing for some reserve to meet the cash requirement of the depositors, the banks lend the balance to the borrow. The amount of reserve to be maintained by the banks is Cash Reserve Ratio which is determined by the central bank.
The derivative or active deposits refer to the deposits which are created out of the percentage of loans and advances granted by the banks. Suppose an individual is sanctioned loan of Rs. 10000 by a bank A. The bank does not give him cash while sanctioning the loan. Instead the bank merely opens an account in the name of individual and credits his account with Rs. 10000. He is then allowed to withdraw this amount whenever he wants. When the bank credits his account with Rs. 10000, it is treated as a new deposit received by the bank. Hence, the bank derives this new deposit from the loan given and the bank has actively created this new deposit. This is the reason why it is always said that loans create deposits. The new deposit created in this manner will add to the money stock of the economy. Whenever the loan is returned by the borrower to the bank, then there is no further possibility of creating new deposit. This results in net decrease in money stock.
Therefore creation of credit or granting of loan adds to money supply to in the economy and the return of loan results in reduction in money supply.
It should also be noted that the banks create active deposits while they purchase assets or securities from others or discounting the bills of exchange or any other negotiable instruments. But the majority of credit is created only out of the loans given.
Process of Credit Creation by Commercial Banks
The multiple credit creation process can be explained with a single bank or more than one bank. The former is called single bank credit creation and the latter multiple bank credit creation model. To explain both these models, let us assume that;
- There are three banks A, B, and C
- The cash reserve ratio is 10% and
- An initial deposit (primary deposit) of Rs. 10000 is made into bank A.
When bank A receives the new deposit its balance sheet will appear as below :
Out of this new deposit of Rs. 10000 the bank has to maintain a reserve of 10% which works out to Rs. 1000. The balance of Rs. 9000, can be lent by the banker. Suppose Bank A lends Rs. 9000 to Mr. P, a borrower, who uses this fund to pay off his creditors. On giving the loan to Mr. P, the balance sheet of Bank A will be :
|Cash (Reserve)Loan to Mr. P|
The creditors of Mr. P may have an account with bank B and so they may deposit Rs. 9000 received from Mr. P in bank B. This is the primary deposit of fresh deposit bank B. Of this the bank will maintain a reserve of Rs. 900 and it may give a loan, of Rs. 8100 to Mr. Q. Then the balance sheet of bank B will appear thus :
|Cash (Reserve)Loan to Mr. Q|
Suppose Mr. Q uses this loan of Rs. 8100 to pay off his creditor who has an account with Bank C. Bank C will, then, get a fresh deposit of Rs. 8100 and it would lend^ Rs. 7290 after keeping a cash reserve of Rs. 810 The balance sheet of bank appear as below :
|Cash (reserve)Loan to Mr. R|
Mr. R may use this loan to repay his creditor who may have an account with Bank D and it would create loan out of the new deposit received. Hence, in the above example, a fresh deposit of Rs. 10000 in Bank A has resulted in the creation of loans to the tune of Rs. 24390 (9000 + 8100 + 7290). If this process continues more amount of credit will be created.
In the above example, we have assumed that each borrower has enabled fresh deposits in different banks. Suppose the amount lent by Bank A is retained by it (because the creditors of Mr. P deposit the money in bank A itself). Hence, the example given above explain the multi bank credit creation model and if it is altered sightly, assume the existence of bank A alone, then it becomes an example for single bank credit creation model.
It is of interest to know the total amount of credit created by the commercial banks in the above example. This could be found out that die following formula K = 1/r. In the formula K is the deposit multiplier and r is the cash reserve ratio. In the above example r = 10%, ie., 1/0.10 which is equal to 10. This means that original deposit will multiply by 10 times if the cash reserve ratio is 10% Suppose we increase the cash reserve ratio to 20% then the multiplier will be 5 and the cash reserve ratio is 5%, the multiplier will be 20. Hence a rise in cash reserve ratio will reduce the volume of credit created and a fall in cash reserve ratio will increase the volume of credit created. We find the total amount of credit created we can use the deposit multiplier calculated above multiply it with the initial deposit In otherwords, Addition aggregate deposits = Fresh deposit x K
In the above example, fresh deposit is Rs. 10000 and the multiplier is 10. Hence the total credit created is 10000 x 10 = 100000.
So far we have explained the credit creation process by the commercial banks. We can also explain the credit contraction process which means, that whenever the depositors withdraw their deposits then the banks will be left with lesser cash to create only lesser credit.
Both the credit creation and contraction are subjected to the following limitations:
- The volume of cash in circulation determines the extent of credit created. With larger volume of cash, the primary deposits will be more thereby the credit created will also be more. Any reduction in the volume of cash will reduce primary deposits and so the credit created.
- Cash reserve ratio, in fact, is a primary determinant of credit created. It has been already shown that higher the cash reserve ratio lesser will be credit created and lower the ratio greater will be the credit created.
- The external drain or the extent of withdrawal of cash by the depositors also determine the volume of credit created. When there is heavy withdrawal of cash by depositors there will be reduction in credit crated and lesser withdrawal will encourage a larger volume of credit created.
- Banking habit of the people is one of the factors influencing the credit created; If people conduct most of their businesses using cheques rather than cash, then the banks will have more cash (primary deposits) to create more credit when people use more of cash rather than cheques, bills, etc.
- The central bank is the leader of the monetary system and its decision to follow a liberal credit policy will encourage more of credit creation and a stringent credit policy will bring down the credit created.
- The availability of a large volume of collateral securities will facilitate larger volume of credit creation and with lesser volume of collateral securities only, lesser credit will be created.
- The business condition prevailing in the country will be one more factor determining the extent of credit creation activity. With prosperity and boom conditions prevailing there is greater opportunity for additional investment and so the credit creation will take place in large scale. During the period of depression and. adversity, as the investment opportunities are very limited, there is no scope for credit creation.