Credit creation
is a procedure whereby the banks and financial institutions create loans and
advances from the public deposits and other sources available to them. The
amount of money deposited for the first time in the bank account is called
primary deposit. The bank lends to others from that amount which can come back
to other banks in the form of secondary deposits. Creation of such secondary
deposits can continue for a long time with the creation of newer and newer
loans from such secondary deposits. With this process, the banking system can
create a large amount of credit with the fixed amount of money deposited in the
banks initially.
We can explain
the process of credit creation in two different scenarios below:
(i) Under Single Bank System:
To explain how
the banking system with a single commercial bank creates credit, suppose that there is a single bank‘Bank X’ and the cash reserve ratio fixed
by the central bank is 20 percent and also assume that the bank does not keep
any other cash balance with itself.
Now, when a
customer say ‘Customer A’ comes to the bank to make a deposit of Rs. 100 at
his/her account, it is called primary deposit. Out of that deposit, the bank
maintains a reserve of Rs. 20 at the central bank to fulfill the CRR
requirement and can lend the remaining Rs. 80 to some customer say ‘Customer
B’. The bank deposits Rs. 80 in B’s account which increases the deposit of the
banking system by Rs. 80. It is called derivative deposit because such a deposit comes
out of the original deposit of Rs. 100. Even if B withdraws that money, that
will ultimately return to the same bank as there are no other banks in the
system. The bank now has to maintain 20 percent of the new deposit Rs. 80 (i.e.
Rs. 16) as cash reserve ratio and can lend the remaining to another customer.
This process continues until the primary deposit of Rs. 100 is all used up in
maintaining the cash reserve ratio.
The whole
process of credit creation can be explained below.
Step
|
Deposit (D)
|
Required Reserves (r.D)
|
Credit Creation (C)
|
Deposit
|
Required Reserves
|
Credit Creation
|
I
|
100
|
0.2*100=20
|
0.8*100=80
|
D
|
r.D
|
(1-r)D
|
II
|
80
|
0.2*80=16
|
0.8*80=64
|
(1-r)D
|
r(1-r)D
|
(1-r)2 D
|
III
|
64
|
0.2*64=12.8
|
0.8*64=51.2
|
(1-r)2 D
|
r(1-r)2 D
|
(1-r)3 D
|
..
|
…
|
…
|
…
|
…
|
…
|
….
|
..
|
…
|
…
|
…
|
…
|
…
|
….
|
..
|
…
|
…
|
…
|
…
|
…
|
….
|
Total 500
|
100
|
400
|
D/r
|
D
|
(1-r)/r)D
|
The total credit
creation is: (1-r)D+(1-r)2 D+(1-r)3 D+(1-r)4 D+…….and
so on
=D{(1-r)+ (1-r)2
+(1-r)3+(1-r)3+……….}
Here, the series
inside the bracket is a declining geometric series with infinite terms, its
summation can be calculated as: S = a/1-r, Where a=first term and r = common
ratio
= {1-r/(1-(1-r)} D
= {1-r/r} D
Credit Creation
= {1-r/r} D
Credit
Creation=Credit Multiplier (1-r/r) × Primary Deposit (D)
Thus, the total
credit creation power depends on the cash reserve ratio. If the CRR ratio is
reduced to 10 percent, total credit creation would be 100/0.1= Rs. 1000
The above system
works perfectly only when the following conditions are fulfilled:
1. People do not
keep cash balances with themselves.
2. The bank need
not keep any extra cash balances with them.
But in most
cases, the above two assumptions do not hold as such the credit creation
capacity of the banking system will be smaller than that given by the above mechanism.
(ii) Multi
Banking System
The process of
credit creation under multiple bank system differs from that of single bank
system basically in one respect - the derivative deposits may no longer return
to the bank where primary deposit was made. It is because the public may choose
other banks to keep the money which is withdrawn from the loan account of a
bank. Whatever the case, the total volume of credit generated remains
unaffected. For example the first bank provides a loan of Rs. 80 to customer A,
out of the deposit Rs. 100 (CRR is 20 percent).
Now, wherever the customer deposits that money (in the same bank or the
other, that amount can create a loan of Rs. 64 only because the rest Rs. 16
should be kept in the form of required reserves. Thus, it does not matter for
the banking system as whole where the deposits are made. The total credit
creation is again the same as in the above case.
This can be
explained with the following example:
Bank
|
Customer Making Deposit
|
Deposit (D)
|
Required Reserves (r.D)
|
Credit Creation (C)
|
Customer taking Credit
|
I
|
Customer A
|
100
|
0.2*100= 20
|
0.8*100=80
|
Customer B
|
II
|
Customer B
|
80
|
0.2*80= 16
|
0.8*80= 64
|
Customer C
|
III
|
Customer C
|
64
|
0.2*64= 12.8
|
0.8*64=51.2
|
Customer D
|
..
|
…
|
…
|
…
|
…
|
…
|
..
|
…
|
…
|
…
|
…
|
…
|
..
|
…
|
…
|
…
|
…
|
…
|
Total
|
500
|
100
|
400
|
Factors Affecting Credit Creation
a) Amount of
Deposit
Higher the cash
collection of the commercial banks in the form of public deposits, the more
will be the credit creation. Deposit collection depends on a lot of factors
like the remittance inflow in the country, interest rate offered by the banks,
rate of inflation, central bank policies regarding money supply, rate of
capital and investment inflow in the country, etc.
(b) CRR
The cash reserve
ratio has a negative impact on the credit creation capacity of the banking
system. When CRR is raised, the amount available for lending from the banks is automatically
reduced as such the whole credit creation process shrinks down.
(b) Excess
Reserves
Besides the cash
reserve ratio, banks maintain extra cash reserve to fulfill the transactions
needs of depositors and to ensure the safety and liquidity of commercial banks. In
this ratio rises, the credit creation capacity of the banking system is reduced
and vice versa.
(d) Leakages
The amount
withdrawn from the bank may not completely return to the banking system as
public may some keep cash with themselves. It reduces the credit creation
capacity of the banks.
(e) Availability
of Borrowers, Securities and Proper Economic Climate
For the credit creation
process to work perfectly, the banking system should be willing to lend all of
their available resources, the individuals should be willing to take loans and
there must be proper economic climate to take credit. For instance, if the economy is in
recession, the individuals will not take loans as such the credit creation
principle does not realize fully.
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