What is Credit Creation by Commercial Bank?
In very simple terms, a bank is separated from other financial banks by credit creation. Credit Creation is the expansion of the deposits. Also, the banks can expand their demand deposits as a multiple of their cash reserves because the demand deposits serve as a principal medium of exchange.
Demand deposits are a very crucial constituent of the money supply. The expansion of the demand deposits means the expansion of the money supply. The entire banking structure is based on credit. The meaning of credit is to get the purchasing power now and promise to pay at some time in the future. And bank credit means the bank loans as well as the advances. A bank keeps a certain part of its deposits as a minimum reserve to meet the demands of its depositors and the rest is lending out to earn an income. The account of the browser is given the loan. Every bank creates an equivalent deposit in the bank. Hence, credit creation means expanding bank deposits.
The Two Pivotal Aspects of Credit Creation
Liquidity
The banks are bound to pay cash to their depositors when they exercise their right to demand cash against their depositors.
Profitability
The banks always look for profit. They are profit-driven enterprises. This is the reason why a bank must grant loans in such a manner that will help to earn higher interest than what it pays on its deposits.
The bank’s credit process is based on the assumption that at any time only a few customers will genuinely need cash. Also, on the other hand, the banks assume that all their customers will not turn up demanding cash against their deposits at one point in time.
Know About the Basic Concepts of Credit Creation
1. Bank as a business institution
One has to believe that banks are a business institution that always tries to maximize profits through loans and the advances from the deposits.
2. Bank Deposits
Bank deposits are the basis for credit creation. Bank deposits are of two types as follows:
a. Primary Deposits-
A bank accepts cash from the customers and opens a deposit in his or their name. This is called a primary deposit and this does not mean a credit creation.
These deposits are simply converted into deposit money from currency money. These deposits form the basis for credit creation.
b. Secondary or Derivative Deposits-
A bank grants loans and advances. Instead of giving cash to the borrower, the bank opens a deposit account in his or her name. This is called the secondary or derivative deposit.
Every loan creates a deposit and the creation of a derivative deposit means the creation of the credit.
Process of Credit Creation by Commercial Banks
A central bank is the primary source of money supply in an economy of a nation through the circulation of currency. It ensures the availability of the currency for meeting the transaction needs of an economy. It also facilitates various economic activities such as production, distribution as well as consumption. For this purpose, the central bank needs to depend upon the reserves of the commercial banks which are the secondary source of money supply in an economy.
The most crucial purpose of a commercial bank is the creation of credit. This is the reason why the money supplied by commercial banks is called credit money. All commercial banks create credit by advancing loans and purchasing securities. They lend money to the individuals as well as to the businesses out of deposits accepted from the public.
Commercial banks are not allowed to use the entire amount of public deposits for lending purposes. They are accepted to keep a certain amount as a reserve with the central bank. This is for serving the cash needs of the depositors.
The commercial banks can lend the remaining portion of the public deposits after keeping the expected amount of reserves.
Factors affecting Credit Creation by Commercial Banks
Factors that have an Effect on the Creation of Credit are as follows:
The capacity of the bank banks to create credits which are a matter of the availability of cash deposits with banks. Also, the capacity to create credit depends on the factors that determine their cash deposit ratio.
The desire of the banks to create credits.
The demand for credit in the market.
Advantages and Limitation of Credit Creation by Commercial Banks
On the advantageous side, the depositors can access a wider range of products that the intermediaries offer that can easily be converted into cash. Investment of the company shares (mutual funds) can also be liquidated in a very easy manner.
On the disadvantageous side, there are several limitations, these are as follows:
Lack of securities.
The Business Environment
Lack of Cash
The habits of the people
Leakages
FAQs on Credit Creation by Commercial Banks
1. What exactly is credit creation by commercial banks?
Credit creation is the process through which commercial banks generate credit, which is a form of money. When banks receive deposits, they are legally required to keep a certain fraction of it as a reserve and can lend out the rest. By lending this money, they create new deposits in the economy. This process, where banks can lend out a multiple of their initial cash reserves, is known as credit creation. It significantly increases the money supply in an economy.
2. What is the formula to calculate the potential credit a bank can create?
The potential for credit creation is calculated using the money multiplier formula. The formula is:
Money Multiplier = 1 / LRR
Here, LRR stands for the Legal Reserve Ratio, which is the minimum fraction of deposits that banks must keep as reserves and cannot lend out. To find the total credit created, you multiply the initial excess reserves by the money multiplier.
3. What are the key assumptions made for the credit creation process to work?
The theory of credit creation is based on a few important assumptions. For the process to work as described in economic models, we assume that:
- All financial transactions, including payments and receipts, are done through banks.
- The entire banking system is treated as a single unit.
- The public does not hold onto cash; any money received is deposited back into a bank.
- The Legal Reserve Ratio (LRR) is constant and determined by the central bank.
4. How does the Cash Reserve Ratio (CRR) affect a bank's ability to create credit?
The Cash Reserve Ratio (CRR) is a key tool that directly controls a bank's credit creation power. A lower CRR means banks have to keep a smaller portion of their deposits in reserve, leaving them with more funds to lend out. This leads to a higher money multiplier and greater credit creation. Conversely, a higher CRR restricts the amount of money banks can lend, which reduces their capacity to create credit.
5. What is the difference between primary deposits and secondary deposits in banking?
Primary deposits refer to the actual cash that the public deposits in a commercial bank. This is the initial money that enters the banking system. Secondary deposits, also known as derivative deposits, are created when a bank grants a loan. The loan amount is credited to the borrower's account, creating a new deposit. These deposits are a result of the bank's lending activity, not new cash from the public.
6. Why is it said that “loans create deposits” and not the other way around?
This statement highlights the core of the credit creation process. While banks need initial primary deposits to start lending, the act of giving a loan itself creates a new deposit. When a bank approves a loan for a customer, it doesn't give them physical cash. Instead, it opens an account in their name and credits the loan amount to it. This newly created account is a secondary deposit. Therefore, the act of granting a loan directly results in the creation of a deposit.
7. Can commercial banks create an unlimited amount of credit?
No, the power of commercial banks to create credit is not unlimited. It is restricted by two main factors:
- The total amount of primary deposits: Banks can only create credit based on the initial cash deposits they hold.
- The Legal Reserve Ratio (LRR): The central bank sets the LRR (which includes CRR and SLR), dictating the percentage of deposits that must be kept as reserves. A higher LRR limits the bank's ability to lend and create credit.
8. How is the money created by commercial banks different from the money created by the central bank?
The central bank (like the RBI in India) creates high-powered money, which includes physical currency (notes and coins) and reserves held by commercial banks. This is the base of the economy's money supply. Commercial banks, on the other hand, create credit money or bank money in the form of demand deposits. This credit money is a multiple of the high-powered money and serves as a medium of exchange but is not legal tender in the same way currency is.
