Credit Creation By Banks
Credit creation is one of the most important functions of the banks.
How the bank creates credit is not a secret. The banks do not keep cent percent reserves against deposits to meet the demand of the depositors. The bank advances the money they receive. Banks promises the depositors to pay whenever they make a demand, which banks are able to do with a very small reserve, because all the depositors will not come to withdraw money at the same time, some withdraw, while others deposit at the same time. In this way banks are able to create much more credit on the basis is a small cash reserve. The bank is able to lend money and charge interest as the bank loan creates a deposit or it creates a credit for the borrower. This is what is meant by the Credit Creation.
In the same way, banks buys securities and pays the seller with its own cheque which is not cash, it is just a promise to pay cash. The cheque is deposited in some bank and a deposit is created for the seller of the securities. This is Credit Creation.
According to Benham, Credit creation implies to a situation when ‘a bank may receive interest simply by permitting a customer to overdraw their accounts or by purchasing securities and paying for them with its own cheques, which increases the total bank deposits’.
Chequable bank deposits are treated as money as by drawing a cheque on his bank a person transfers some amount of funds to another person. Deposits are created not only by the public depositing their money with the banks but also by the banks themselves when they give loans to the businessmen or borrowers. The creation of bank deposits themselves by the banks while giving loans to businessmen is called credit creation by the banks.
The creation of bank deposits in excess of cash reserves with them has become possible because of the fractional reserve system.
Cash Reserve Ratio (CRR) – The fraction of bank’s total deposits that are held in cash reserves with the bank is called cash reserve ratio.
Let’s assume that the cash reserve ratio is 10 percent which the bank has to maintain. Then, if a person deposits ₹ 1000 with the bank, then the bank will keep 10% of ₹ 1000, which is ₹ 100 as reserve and give the loans of the remaining amount of ₹ 900 to borrowers or to businessmen. When bank gives loans of ₹ 900, it generally credits this amount in chequables deposits of the borrower or businessman. Before it is withdrawn the chequable deposits of the bank rise to ₹ 1900. The extra ₹ 900 of the deposits which the bank created itself will also be treated as money. In this way, the bank created extra ₹ 900 as if out of thin air.
This process of credit creation does not stop’s here, it goes on up to a certain point.
When ₹ 900 will be transferred by the borrower to another person by issuing a cheque to him, this may be deposited in another bank whose reserves will increase by ₹ 900. With 10% as reserve ratio, the other bank will keep 10% of ₹ 900 which is ₹ 90 and the remaining ₹ 810 will be given as loan to some other borrower by creating ₹ 810 to his chequable deposits.
This process will go on and creation of credit will go on increasing until they rise by 1/r, where r is reserve ratio. 1/r shows deposit multiplier.
If the reserve ratio is 10%, then the deposit multiplier will be equal to 1/0.10 = 10. So, with the original cash deposit of ₹ 1000 will cause total deposits to rise by 10×1000 = 10000.
If the cash reserve ratio is 5% then the deposit multiplier will be equal to 1/0.05 = 20. So, with 5% as cash reserve ratio banks will create with ₹ 1000 total deposits equal to 20×1000 = 20000.
In this way the fractional reserve system enables the banking system as a whole to create much more deposits or credit than the total amount of the original deposits of cash.
The credit creation by the banks depends on the cash reserve ratio. The smaller the cash reserve ratio, higher the credit creation.
Deposit Multiplier (dm) and Credit Multiplier (Cm) –
The cash deposits in the banking system leads to multiple expansion (or credit creation) in the total deposits, which is known as deposit multiplier or credit multiplier.
The magnitude of deposits multiplier depends on the cash reserve ratio (CRR).
Deposit Multiplier = dm = ∆D/∆R = 1/r
r = cash reserve ratio
Deposit multiplier is the reciprocal of cash reserve ratio (CRR).
For example, when cash reserve ratio is 20%, that is 0.20,
then the deposit multiplier will be 1/0.2 = 5.
If the cash reserve ratio is raised to 25%, that is 0.25,
then the deposit multiplier will be 1/0.25 = 4.
Credit Multiplier (Cm) – It measures the extent by which the banking system creates credit as a result of new increase in primary deposits which they use as reserves.
Credit Multiplier = Cm = ∆C/∆R
∆C = credit created by the banks
∆C = ∆D – ∆R
∆R = increase in the primary deposits as cash with banks
Cm = (1-r)/r
For example, If the cash reserve ratio is 20%, then
Cm = (1-0.20)/0.20 = 0.8/0.2 = 4
Benham has pointed out three limitations on the credit creating power of the banks –
1. The amount of cash in the country.
Credit is created on the basis of cash. The higher the amount of cash, the larger the amount of credit that can be created by the banks. But the amount of cash that a bank may have is controlled by the central bank. It may increase or decrease it and credit will expand or contract accordingly. The central bank controls the extent of credit that banks can create.
2. The amount of cash which the public wishes to hold.
It depends on the habit of the peoples regarding the use of cash. If the peoples have habit of using cash and not cheques, then as soon as the credit is granted, the borrower will draw the cheque and get cash. This will reduce the reserves of the bank, so the less credit they will be able to create. In the opposite (other) case, they will be able to create more credit.
3. The minimum percentage of cash to deposits (cash reserve ratio), which the banks have to maintain.
If the cash reserve ratio is high, then the banks capacity to create credit will be low and vice versa.
The banks can’t let the cash reserve ratio fall below a certain minimum. When that minimum is reached, banks power to create credit comes to an end.
# The amount of money which public wants to hold as deposits in the banks.
The credit creation by the banks depends on the money deposited by the public, which in turn depends on the rate of interest paid by the banks to the depositors on the deposits with them. Other things being same, the higher the rate of interest, greater the amount of money the public will deposit with the banks, which in turn will increase the credit creation by the banks.