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Credit Creation

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25 views3 pages

Credit Creation

Uploaded by

anjalimotwani260
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Credit Creation by a Commercial Bank

A commercial bank is a dealer of credit. It creates money based on


cash deposits. Further, it issues new money through its loan
operations and creates credit or expands the monetary base of a
country.

Therefore, this process of credit creation leads depositors to believe


that they have money with the bank. Also, borrowers believe that
they owe a certain amount of money to the bank. Let’s understand
credit creation through an example.

Source: Kisspng

Example:

Let’s say that a bank receives a sum of Rs.1,000 as a demand deposit.


Also, let’s assume that the Cash Reserve Ratio (CRR) is 20%.

Therefore, the bank retains Rs.200 and lends the remaining Rs.800 to
a borrower. While the depositor claims that he has Rs.1000 with the
bank, the borrower has Rs.800 too.
Therefore, a single bank manages to create a credit of Rs.800.

If we extend this example to the entire banking system, then it offers


an interesting insight.

Let’s say that the borrower takes a loan of Rs.800 from Bank A and
deposits it with another bank (Bank B). Bank B retains 20% of the
deposited amount (Rs.160 = 800×20%) and lends the remaining
Rs.640 to another borrower.

Further, let’s say that the second borrower deposits the loan amount
of Rs.640 with Bank C. This bank also retains the CRR of 20%
(Rs.128 = 640×20%) and lends the remaining Rs.512 to the third
borrower. This process continues until the time that the deposited
sum is nearly equal to the CRR.

Just to give you a perspective, a single deposit of Rs.1000 with a


CRR of 20% (1/5th) leads to the credit creation of Rs.5000.
Therefore, the size of the multiplier is 5 (1000×5 = 5000).

Limitations of Credit Creation


The multiple credit creation process, as explained in the example
above, depends on various factors:

1. A lot depends on the Cash Reserve Ratio (CRR). In fact, there


is an inverse relationship between the CRR and the size of
the multiplier. Therefore, if the CRR is 100%, then the bank
cannot create credit.
2. What happens when a society is in an economic depression?
People stop taking loans. If a bank cannot lend, then it
cannot create credit. In other words, the credit creation
depends on the amount of loan that a bank grants.
3. The size of the cash deposit is an important factor too. If a
bank has a smaller cash base, then it has a lesser scope for
creating credit.
4. A commercial bank lends money against accepted securities.
The bank specifies the securities against which it
offers loans. Also, the value of the securities must be equal
to the amount of the loan. Even if the bank has a large cash
base for creating credit, it will not lend money if it does not
get acceptable security.
5. The Central Bank (Reserve Bank of India) substantially
control the credit-creating power of all commercial banks. It
has certain instruments which enable it to increase or
decrease the volume of credit creation. Further, it also
controls the direction and purpose of credit that the banks
offer. All banks accept the regulations of the Central Bank as
it is their lender of last resort.

Solved Question
Q1. What is credit creation by commercial banks?

Answer: Commercial banks can expand the deposits they receive


through loans, resulting in an expansion of the monetary base of a
country. This is credit creation.

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