How Commercial Banks Create Credit Through the Deposit Multiplier Process
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Commercial banks engage in credit creation by using deposits as the source of loans. When a customer deposits money in a bank, the bank is required to keep a percentage as reserves but can loan out the rest. For example, if a customer deposits Rs. 1000 and the reserve ratio is 20%, the bank can loan Rs. 800. This loan may then be deposited in another bank, allowing further lending in a multiplying effect. The credit multiplier calculates this effect, with a 20% reserve ratio allowing deposits and loans to increase by a factor of 5 times the initial deposit through the banking system.
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How Commercial Banks Create Credit Through the Deposit Multiplier Process
- 1. CREDIT CREATION BY COMMERCIAL BANKS N E JOHN C S O U N K O U M M I A C R S SRR & CVR GOVT.DEGREE COLLEGE Vijayawada
- 2. CREDIT CREATION BY COMMERCIAL BANKS Credit creation: Credit creation is one of the primary functions of commercial banks. Credit money like legal tender money affects the economic activities. Deposits – Credit: Deposits are the sources of credit. Deposits were created when providing Credit . So credit create deposits and as well as deposit creates credit. Deposits are of two types. Primary Deposits: These deposits are made by receiving money directly from public and the firms by the banks. Derived deposits: These deposits were made by the banks when they sanction the loans.
- 3. PROCESS OF CREDIT CREATION BY THE BANKS The process of credit creation can be explained with the following illustration. Assume there are three banks A, B, and C. A person deposits Rs 1000/- in bank A and this is liability also an asset to the bank. The assets and liabilities were shown in a balance sheet. Now to get the profits banks tries sanction loans of Rs 1000/-. Assume CRR is 20%. Now bank A can sanction loan of only Rs. 800/- and remaining Rs. 200/- can be kept in bank as a reserve money. Now we can show the assets and liabilities in a balance sheet which is depicted next slide.
- 4. TABLE OF ‘A’ BANK ASSETS AND LIABILITIES The person who took Rs. 800/- as loan from the bank ‘A ‘and deposited it in the bank ’B’. But the bank ‘B’ has to kept 20% of its deposits means Rs 160/- and has to lend only Rs 640/-. Now the balance sheet of bank ‘B’ is shown below. Assets Total Liabilities Total Cash reserve Loans and advances 200 800 Deposits 1000 1000 1000
- 5. TABLE OF ‘B’ BANK ASSETS AND LIABILITIES The person who took Rs. 800/- as loan from the bank ‘B ‘and deposited it in the bank ’C’. But the bank ‘B’ has to kept 20% of its deposits means Rs 128/- and has to lend only Rs 512/-. Now the balance sheet of bank ‘C’ is shown below. Assets Total Liabilities Total Cash reserve Loans and advances 160 640 Deposits 800 800 800
- 6. TABLE OF ‘C’ BANK ASSETS AND LIABILITIES When we look at the above banks balance sheets the deposits are in the banking system were 1000+800+640+512+…..and so on. Finally it will be the amount of Rs 5000/- Assets Total Liabilities Total Cash reserve Loans and advances 128 512 Deposits 640 640 640
- 7. CREDIT MULTIPLIER It can be explained with the following equation. k=1/r k: Credit multiplier r: Cash Reserve Ratio In the above example r=20% k=1/r = 7/20x100=5. This means the initial deposit increases by 5 times. The deposits started with Rs.1000/- can be created by Rs 5000/- by the banks.