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Credit Creation and Limitations of a Bank


Posted Date: 12-Mar-2010  Last Updated:   Category: Education    
Author: Member Level: Gold    Points: 15


What is Credit Creation of a Bank? What are the Limitations of a Bank? If you have such questions in your mind read this article. It explains the process of credit creation in details and describes the process of credit creation by commercial banks.



Credit creation is one of the important functions of a commercial bank.It constitutes the major component of money supply in the economy commercial banks differs from other financial institutions in this aspect. Other financial institutions transfer money from the lenders to the borrowers. Commercial banks while performing the same function, they create credit or bank money also. Professor Sayers says, "Banks are not merely purveyors of money, but in an important sense, they are the manufacturers of money".

The process of credit creation occurs when banks accepts deposits and provide loans and advances. When the customer deposit money with the bank, they are called primary deposits. This money will not be withdrawn immediately by them. Hence banks keeps a certain amount of deposits as reserves which is known as cash reserve ratio and provide the balance amount as loans and advances. Thus, every deposit creates a loan. Commercial banks give loans and advances against some security to the public. But the bank does not give the loan amount directly. It open an account in the name of the borrower and deposits the amount in that account. Thus, every loan creates a deposit. The loan amount can be withdrawn by means of checks. They create a deposits while lending money also. These deposits created by banks with the help of primary deposits are called derivative deposits.

Customers use these loans to make payments. While paying they issue a checks against these deposits. The person who receives the checks, deposit it in another bank. For that bank, this will be the primary deposit. A part of the deposit will be kept as a reserve and the balance will be used for giving loans and advances. This process is repeated by other banks. When all the banks involve in this process, it is called Multiple Credit Creation.

This can be explained with an example. Suppose, if a person deposits Rs. 1,000/- in a bank. Rs.1000/- is the primary deposit. The minimum cash reserves ratio is 10% to meet the demand of its depositors. Now the bank can lend out Rs.900/-

i.e. Primary deposit - Cash reserve = Derivative deposit.
Rs.1,000 - Rs.100 = Rs.900 (10% of 1000 is Rs.100)

The bank will give the amount to his creditor only in his account which is opened in his name. The borrower can deposit the amount with the bank. The bank can lend out Rs.810/- out of Rs.900/-, which has come back to the bank in the second round as primary deposits. This process will continue and if there is no cash leakage the credit creation would be processed as in the below figure:

Figure

This process can be explained with a formula.
Total credit created = Original deposit x Credit multiplier co-efficient.

Credit multiplier co-efficient = 1/CRR x 1/10% = 1/10/100 = 10

Total Credit created = 1000 x 10 = 10000

If CRR rises to 20%, the credit created will be 1/20/100 = 100/20 = 5

So 1000 x 5 = Rs.5000/-

It is clear, that the amount of credit created depends upon the cash reserve ratio. Higher the CRR, lesser will be the credit created and vice versa.

Limitations:

  • Credit creation depends upon the amount of deposits.
  • There exists an inverse relation between credit creation and cash reserve ratio. During inflation the CRR will be high to reduce credit.
  • Banking habits of the people are well developed, it will lead to expansion of credit.
  • Loans are sanctioned by banks against some security. If enough securities are available, then credit creation will be more and vice versa.
  • If all the commercial banks, follows a uniform policy regarding CRR, this credit creation would be smooth.
  • If the liquidity preference of the people is high, the credit creation will be less and vice versa.
  • If business conditions are bright then demand for credit will be more.
  • Customers should be willing to borrow from the banks to facilitates credit creation.
  • Credit control policy of the Central Bank, for example during the depression, the RBI encourages the commercial banks to expand credit.


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