Introduction

There is no limit on probable money deposits made by customers in a bank. However, in India, the Central Bank of India, the Reserve Bank has put a limit to which the banks can deposit the amount of loans in their possession. This is done to make sure that the banks are not over lending.

Credit Creation

Demand deposits are considered an important part of the money supply. By increasing demand deposits, the money supply can be expanded. The banking system is usually based on credit. Credit means getting the purchasing power now and paying for it in the future Bank credit usually means bank loans and advances.

Banks keep a portion of the deposits as a minimum reserve to meet the demands of depositors. The other portion is distributed as loans to the customers. The loan is deposited to the borrower’s account. So, every loan creates an equivalent deposit in the bank. This is known as credit creation. In other words, credit creation is the process of expansion of bank deposits.

Most important aspects of credit creation are as follows:

Profitability: Banks are profit-driven enterprises and hence they will derive profit from the credit creation process. It will pay lesser interest to the customers for deposits and apply more interest rates in its loans offered to customers.

Liquidity: The banks must pay the depositors the required amount from their deposits any time they ask for the money. The banks must be liquid to a certain extent all the time.

Based on the assumption that all the customers won’t demand cash against their deposits at one point in time, the bank’s credit creation has been initiated.

Cash Reserve Ratio (CRR)

Banks know that all their customers won’t need all the cash they have deposited in the bank at the same time. So, they keep a certain portion of the deposit available with them to meet the demands and distribute the excess deposits as loans. The Cash Reserve Ratio (CRR) is the percentage of total deposits a bank must hold in cash reserves to meet the demands of the depositors.

Phenomenon of Money Multiplier

The process of the creation of money via credits in the economy is referred to as the money multiplier. It is based on the fractional reserve bank system. It is related to the maximum money supply associated as there are changes in the deposited money which keeps changing. The money multiplier system is mostly seen in commercial banks. These banks inject the extra money left after maintaining CRR, into the market in the form of loans to maintain the liquidity of the market system.

Disadvantages of Credit Creation

It is noteworthy that banks prefer to create credit as much as possible. However, this may not be many ways to create credit, such as limitations put by the central bank, etc. Some of the limitations make the credit creation process non-profitable. Therefore, a bank continues to create additional credit as long as –

• Low chance of the loans turning into bad debts
• I interest rate that banks charge on loans and deposits is higher than the interest that the bank offers to depositors for the money deposited in the bank.

Prime factors that affect the creation of credit are as follows:

• Ability of banks to create credit.
• Willingness and requirement of the banks to create credit
• Restricts demand for credit in the market.

Capacity to create credit is a matter of the following factors:

• Availability of cash reserve deposits with banks
• Factors determining cash deposit ratios of the banks

As regards the demand for credit:

• Existence of demand in the market
• Borrower’s’ Creditworthy is always important (to avoid bad debts)
• Reasonability of the amount of loan granted should not exceed the paying capacity of the borrower.

Leakages

• In case banks are not willing to use their surplus funds to offer loans, then it should mean that the economy is headed toward a recession.
• In case the public withdraws money and holds it with them, or in the case, the public keeps money as deposited for shorter time periods, that reduces the credit creation capacity of the banks.

Central Bank’s Policy

• In countries like India, the central bank often limits the credit creation process of banks by putting limits.
• This is done to stop commercial banks from over-lending at high rates that may exploit customers.
• This also makes sure that the commercial banks have the necessary reserve required for their operation and maintain regular limits to run the business smoothly.

Other Key Concepts Related to Credit Creation

Bank Deposits – Bank deposits form the basis for credit creation and are of two types:

• Primary Deposits – A bank collects cash from the customer and opens a deposit account in the individual’s name. This is called a primary deposit. Although this is not for credit creation, it forms the basis for the creation of credit.
• Secondary or Derivative Deposits –Instead of giving cash to the borrower, the bank offers loans and advances and opens a deposit account in the borrower’s name. This is called the secondary or derivative deposit.
• Credit Multiplier – For a certain amount of cash, a bank can create a credit multiple times. In this process of multiple credit creation, the grand total amount of derivative deposits that a bank creates is a multiple of the initial cash reserves.

Conclusion

Credit creation is an important topic in banking and commerce. As there are limitations to credit creation, learning about them is necessary from a banking point of view. Without the limitations applied, the credit creation process would create an issue of overloading as well as exploitation. Therefore, limitations to credit creation and money multiplying are essential and must be followed by one and all.

FAQs

Q1. What are the two most important aspects of credit creation in terms of a bank’s outlook? Illustrate briefly.

Ans. The two most important aspects of credit creation are:

Profitability: Banks are profit-driven enterprises and hence they will derive profit from the credit creation process. It will pay lesser interest to the customers for deposits and apply more interest rates in its loans offered to customers.

Liquidity: The banks must pay the depositors the required amount from their deposits any time they ask for the money. The banks must be liquid to a certain extent all the time.

Q2. What is the Cash Reserve Ratio (CRR)?

Ans. The Cash Reserve Ratio (CRR) is the percentage of total deposits a bank must hold in cash reserves to meet the demands of the depositors.

Q3. What is meant by money multiplier?

Ans. The process of the creation of money via credits in the economy is referred to as the money multiplier. It is based on the fractional reserve bank system.