- Commercial banks can create credit through their loan operations, expanding the monetary base without issuing new money. They lend out amounts greater than deposits by creating new deposits through loans.
- This credit creation process allows commercial banks to provide finance to all sectors, developing the economy. Bank deposits that arise from loans and purchases are called "derivative deposits" as banks play an active role in their creation.
- When a deposit is made in one bank and then withdrawn and deposited in another, the banking system can multiply the initial deposit into a much larger total deposit amount through the credit creation process across multiple banks, subject to required reserve ratios.
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Credit creation of commercial banks
1.
2. •It is a process through which bank can create credit from the initial deposits.
•A commercial bank is called a dealer of credit or factories of credit.
•It can create credit i.e. can expand the monetary base of a country. It does so
not by issuing new money but by its loan operations.
•They advance much more than what the collect from people on the basis of
the cash deposits.
• The process of credit creation is that the depositors think they have so much
money with banks and borrowers from bank say they have so much money
with them. Summing the two, we find an amount more than the cash deposit.
•Through the process of credit creation, commercial banks provide finance to
all sectors of the economy thus making them more developed than before.
3. •The basis of credit money is the bank deposits.
•The bank deposits are of two kinds i.e.
(i) Primary deposits
(ii) Derivative deposits
4. •Primary deposits arise or formed when cash or cheque is deposited by customers.
•When a person deposits money or cheque, the bank will credit his account.
•The customer is free to withdraw the amount whenever he wants by cheques.
•These deposits are called “primary deposits” or “cash deposits.”
•It is out of these primary deposits that the bank makes loans and advances to its customers.
•The initiative is taken by the customers themselves. In this case, the role of the bank is
passive.
•So these deposits are also called “passive deposits.”
5. •Bank deposits also arise when a loan is granted or when a bank discounts a bill or
purchase government securities.
•Deposits which arise on account of granting loan or purchase of assets by a bank are
called “derivative deposits.”
•Since the bank play an active role in the creation of such deposits, they are also known
as “active deposits.”
6. • There are many banks, say A,B,C,D etc., in the banking system which is considered as a
single unit.
• Each bank has to keep 20 percent of its deposits in reserves. In other word 20 per cent
is the required ratio fixed by law.
• The first bank has Rs. 1,00,000 as deposits.
• The loan amount drawn by the customer of one bank is deposited in full in the second
bank, and that of the second bank into the third bank, and so on.
• Each bank starts with the initial deposit which is deposited by the debtor of the other
bank.
7. LEGAL RESERVE RATIOS
C
CASH RESERVE RATIO (CRR)
Certain percentage of total bank deposits
are to be kept in current account of RBI.
Current rate = 3%
STATUTORY LIQUIDITY
RATIO (SLR)
It is required to maintain in the form of
gold, govt. approved securities etc.
Current rate = 18%
8. •When the bank buys government securities, it does not pay the
purchase price at once in cash.
•It simply credits the account of the government with the purchase
price.
•The government is free to withdraw the amount whenever it wants
by cheque
•The power of commercial banks to expand deposits through loans,
advances and investments is known as “credit creation.”
9. •The banking system as a whole can create credit which is several times more than the
original increase in the deposits of a bank. This process is called the multiple-expansion or
multiple-creation of credit.
•Similarly, if there is withdrawal from any one bank, it leads to the process of multiple-
contraction of credit.
•The process of multiple credit-expansion can be illustrated by assuming
(i)The existence of a number of banks, A, B, C , D etc., each with different sets of
depositors says X,Y,Z etc.
(ii) Every bank has to keep 20% of cash reserves.
(iii) A new deposit of Rs. 1,00,000 has been made with Bank A buy depositor X to start.
10. •Suppose, a Person X deposits Rs. 1,00,000 cash in Bank A.
•As a result, the deposits of Bank A increase by Rs. 1,00,000 and
cash also increases by Rs. 1,00,000. The balance sheet of the Bank A
would be :
Balance Sheet of Bank A
ASSETS LIABILITIES
CASH RS 1,00,000 DEPOSITS RS 1,00,000
11. •CRR= 20%
•Now Bank A has rupees 20,000 with it.
•Remaining 80,000 should be lended or invested in securities.
Balance Sheet of Bank A
ASSETS LIABILITIES
CASH Rs 1,00,000 DEPOSITS Rs 1,00,000
LOAN Rs 80,000 NEW DEPOSITS
( Created) Rs 80,000
TOTAL Rs 1,80,000 TOTAL Rs 1,80,000
12. •Now Person Y withdraws his deposits through cheques and deposit the
whole amount in Bank B.
•So, now Bank A has to give whole amount to Bank B which is equal to Rs
80,000.
•As the newly created deposits of Rs 80,000 has been withdrawn , the
balance sheet of Bank A is as follows :
Balance Sheet of Bank A
ASSETS LIABILITIES
CASH Rs 20,000 DEPOSITS Rs 1,00,000
LOAN Rs 80,000 NEW DEPOSITS 0
TOTAL Rs 1,00,000 TOTAL Rs 1,00,000
13. •Now the assets of Person Y is Rs 80,000 which he keeps in Bank B.
•In the initial stage Rs 80,000 is both the asset and also the liability of Bank B
•As a result, the deposits of bank B is Rs. 80,000 and cash is also Rs. 80,000. The
balance sheet of the Bank B would be :
Balance Sheet of Bank B
ASSETS LIABILITIES
CASH RS 80,000 DEPOSITS RS 80,000
14. •CRR= 20%
•Now Bank B has rupees 16,000 with it.
•Remaining 64,000 should be invested
Balance Sheet of Bank B
ASSETS LIABILITIES
CASH Rs 80,000 DEPOSITS Rs 80,000
LOAN Rs 64,000 NEW DEPOSITS
( Created) Rs 64,000
TOTAL Rs 1,44,000 TOTAL Rs 1,44,000
15. •Now Person Z withdraws his deposits through cheques and deposit the whole
amount in Bank C.
•So, now Bank B has to give whole amount to Bank C which is equal to Rs
64,000.
• Therefore the cash with Bank B falls to Rs 16,000 ( 80,000- 64,000 )
•As the newly created deposits of Rs 64,000 has been withdrawn , the balance
sheet of Bank B is as follows :
Balance Sheet of Bank B
ASSETS LIABILITIES
CASH Rs 16,000 DEPOSITS Rs 80,000
LOAN Rs 64,000 NEW DEPOSITS 0
TOTAL Rs 80,000 TOTAL Rs 80,000
16. Name of the Banks Deposits (RS) CRR (20%) Loans (Rs)
Bank A (Initial
Deposit)
1,00,000 20,000 80,000
Bank B 80,000 16,000 64,000
Bank C 64,000 12,800 51,200
Bank D 51,200 10,240 49,960
Bank E 49,960 9,992 39,968
Total 3,45,160 69,032 2,85,128
Deposits created by the banking system = Rs 3,45,160 – 1,00,000
= 2,45,160
17. •The expansion of the deposits depends upon the CRR.
CRR < : larger expansion of credit
CRR > : smaller expansion of Credit
Example : CRR = 20%
the total deposit expansion from cash deposit of Rs 1,00,000 = Rs 3,45,160
The total deposit expanded was more than 3 times the original cash deposit.
18. The deposits of cash in the banking system leads to multiple expansion in the
total deposits which is known as credit multiplier or money multiplier or
deposit multiplier.
Credit Multiplier (cm) = 1 / r
r = cash reserve ratio
CRR = 20% CRR = 25%
i.e. 0.20 or 1/5 i.e. 0.25 or 1/4
therefore cm = 1 therefore cm = 1
1/5 1 /4
= 5 = 4
19. •Amount of Cash
•Cash Reserve Ratio
•Nature of Business Conditions in the Economy
•The Banking Habits of the People
•Leakages in Credit-Creation
•Liquidity Preference
•Monetary Policy of the Central Bank
•Sound Securities