Banking Awareness : Credit Creation by Commercial Banks

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Credit Creation by Commercial Banks

Creation of credit is an important function of a commercial bank. Prof. Sayers said “Banks are not merely purveyors of money but, also in an important sense manufacturers  of money”. In a modern economy Bank’s deposits form a major proportion of total money supply.

A bank’s demand deposits arise mainly from Cash deposits by customers and Bank Loans and Investments.

Cash Deposits By Customers

These are termed as primary deposits as they arise from the actual deposits of cash in a bank made by its customers. In receiving such deposits, the bank plays a passive role. The creation of primary deposits, however is nothing but transforming the currency money in to deposit money.

Bank Loans And Investments:

These are termed as derivative or active deposits. The derivative deposits are lent in the form of loans or advances, discounting of bills or used for purchasing securities or other assets.

Deposit account in the name of the customer or seller, credits him with the amount of loan granted or value of security purchased, subject to withdrawl by cheque, as required. Hence loans advanced or purchases of securities creates deposits.

Thus every loan creates a deposit. They increase the quantity of bank money. The size of derivative demand deposits is determined by the banks lending and investment activities. There will be a constant inflow and outflow of cash with the banks. For the sake of liquidity and safety some proportion of total deposit must be maintained in cash, for e.g. :- 10% to 20% to meet the demand for cash at the counter. This is known as Cash Reserve Ratio.

Primary deposits serve as a basis for creating derivative deposits, that is credit creation, and for increasing money supply. Commercial banks are profit seeking institutions and when they find that large volume of cash received lies Idle, they use these resources for advancing loans or for making investment in securities, shares etc. there by earning high rate of interest. The creation of credit also depends on excess cash reserves or cash reserve ratio. The derivative deposits are used as working capital.

When the borrower withdraws money from his loan account by cheque it is deposited by the payee in some other bank. Those banks again create deposit on the basis of fresh deposits received after keeping required reserves. Ultimately, the total volume of credit or derivative deposits or bank money created by all banks would be a multiple of the original amount of new cash reserves in the system. Thus multiple expansion of credit takes place.

Example:

Suppose the Cash Reserve Ratio is 20% and a person deposits Rs. 10,000/- with Bank of India. This is primary deposit. The bank keeps Rs. 2000 as CRR and balance of Rs. 8000 is used for granting credit.

Now suppose Bank of India lends Rs. 8000 to Mr. A and Mr. A pays a cheque of Rs. 8000 to Mr. B, who has an account in Bank Of baroda. Then Bank Of Baroda receives Rs. 8000 as primary deposit. It keeps Rs. 1,600 (20%) as CRR and excess amount of Rs. 6,400 is used for giving credit. Now if, Mr. C is granted this loan and Mr.C gives a cheque of Rs. 6,400 to another person who may deposit it in Bank of Maharashtra. Bank of Maharashtra will keep Rs. 1,280 as CRR and issue a loan of Rs. 5,120. This process continues until the original excess reserves of Rs. 8000 with the first Bank of India, have been parceled out among various banks and have been required resources. As a result, the aggregate of derivative deposits in the entire banking system, approximates 5 times the initial derivative deposit over a period of time.

Process of Multiple Expantion of Credit

In the above Eg., the credit expansion is five times the initial excess reserve of Rs. 8,000 when CRR is 20%.

Symbolically,

Where TC = Total Credit

PD   = Primary Deposit.

PCR = Primary cash Reserve.

CCR = Cash Reserve Ratio.

Cash Creation = 10,000-2000 x 100 = 8000 x 100 = 40,000                                               

20       20

The Credit Multiplier depends on CRR.

      r = CRR

If CRR is 20 % then, credit multiplier will be

The Multiple expansion of credit is the inverse of CRR maintained by banks. Higher the CRR,

Lower the expansion of credit and vice versa.

Assumptions:

The bank deposit multipler, discussed above, is based on the following assumptions:

1. There is no leakage from the banking system. All the money should remain with banking system.
2. The banks must receive new deposits.
3. They must be willing to make loans or buy securities.
4. The CRR remains constant through all the stages.
5. People must be willing to borrow.
6. The business conditions are normal.
7. There is no credit control policy of central bank.
8. There should be popular banking habit in the country and a well developed banking system.

Thanks,

Team GovernmentAdda