Credit Creation Process in Commercial Banks


Credit creation refers to the unique power of the banks to multiply loans and advances. With a little cash in hand, the banks can create additional purchasing power lo a considerable degree. It is because of the multiple credits creating power that the commercial banks have been aptly called the 'factories of credit' or 'manufactures of money'. According to Newlyn. "Credit creation refers to the power of commercial banks to expand secondary deposits either through the process of making loans or through investment in securities." To Halm, "The creation of derivative deposits is identical with what is commonly called the creation of credit.”
Stages in Credit Creation
Let the banking authority has decided that the cash reserve ratio is 20 percent. So, the bank must keep 20 percent of its current deposit in the form of cash to make cash payments to persons who come to withdraw money.
STAGE- 1 A person called A, deposits Rs.100 in the bank. As a result the bank’s deposits increases by Rs.100. As per rule the bank keeps 20% of 100 as cash. This comes out to be Rs.20. So the bank keeps Rs.20 to make cash payments. Now deduct 20 from 100. 100 – 20 = 80. So the bank can use Rs.80 to give loan.
STAGE- 2 A person called B approaches the bank to take a loan of Rs.80. After the bank gives this loan, it can claim the amount from B in future. This means that by giving loan to person B, the bank can create another deposit Rs.80. Now calculate the total deposit with the bank First, person A deposited Rs.100. By giving loan to B, the bank is able to claim Rs.80.
So after two steps the bank has total deposit of Rs.180. i.e 100 + 80 = 180
STAGE- 3 Another person called C wants a loan from the bank. How much amount of money the bank can give as loan to C? In the previous step we saw that, the bank could increase its deposit by Rs.80 by claiming the amount from B. As per rule it has to keep 20% of 80 as cash before giving further loan to anybody. 20% of 80 = 16. So the bank will now keep Rs.16 as cash and give the rest of the amount as loan. 80 – 16 = 64. So the bank can give Rs.64 as loan to C. Again by claiming this amount from C, the bank can create another deposit of Rs.64 in stage 3.
Continuing from the previous two steps, we can say that, after three steps the total deposits with the bank has increased upto 180 + 64 = 244. Or 100 + 80 + 64 = 244.
This chain will continue for some time. But when it will come to an end? You know that in each round the bank keeps 20% of the increase in the deposit as cash. You also know that the bank started with an increase in its deposit by Rs.100 in step 1. So the process of credit creation (or increase in deposits) will come to an end when 20% of the deposits of each and every round taken together become 100 itself.
The credit creation capacity of a bank depends on the cash reserve ratio. If the cash reserve ratio is higher, then the bank has to keep more cash to make payments to public and accordingly, fewer amounts will be available for giving loans. So less credit will be created. Credit creation will be higher, if the cash reserve ratio is lower.

Sunday, 10th Apr 2016, 11:06:56 AM

Add Your Comment:
Post Comment