Banks engage in credit creation by lending out more money than they hold in deposits. They are able to do this through the process of credit multiplication. When a bank receives a deposit, it is only required to hold a portion, called the legal reserve requirement, as reserves. It can then lend out the remaining amount. When those loans are deposited in other banks, they become part of the money supply and more loans can be issued based on the new deposits. In this way, the initial deposit is multiplied across the banking system, allowing banks to collectively lend out much more money than the total of all deposits. Central banks control the money supply and flow of credit by setting the legal reserve requirement ratio.

1. CREDIT CREATION
Chitransh Waghmare

2. Banks : The Creators of Credit
 Through the process of credit Creation banks
provide finance to all the sectors of economy,
and thus Called “ Factories of Credit”.
 They advance much more than what they
receive as deposits.

3. Basics of Credit Creation
 The money that banks possess, comes from
bank deposits.
 Bank Deposits are of two Kinds :
 Primary deposits
 Secondary or derivative deposits

4. Process of Credit Creation
 The process can be better understood with two
assumptions :
 The entire banking system is one unit
 All transactions flow through this unit

5. Process of Credit Creation
 Any experienced banker knows two things by
experience :
 Not all the depositors approach the bank for
the withdrawal of money at the same time and
will never withdraw all money at once.
 There would be constant flow of deposits in
the bank and credit could be given.

6. But.. There is something that
controls Credit too !!!
 Central Banks imposes a requirement on the
commercial banks to keep a certain
percentage of total money supply with
themselves as reserves.
 This is Legal Reserve requirement (LRR)
 These act as a strong catalyst in controlling
the flow of credit when required.

7. What forms the LRR
 The Legal reserve requirements is formed
with:
Cash Reserve Ratio (CRR)
Part of money supply banks need to keep with
the central Bank.
Statutory Liquidity Ratio (SLR)
Part of money supply banks need to keep with
themselves, to maintain directed level of
liquidity.

8. Lets take an example of credit
creation
 Suppose, the initial deposits with the bank is
Rs. 1000
 And the LRR is 20 %
 Which implies that the bank is free to lend 80%
of the money which remains as balance.

9. Observe the Table
Deposits Loans LRR (20%)
Initial Deposits 1000 200 200
Round 1 800 640 160
Round 2 640 512 128
Total 2440 1352 448

10. What did we learnt ?
 Based on the example, Its Clear that :
 The banks are able to create more credit than
that of the initial deposit received.
 This Function of Banks is Called “ Money
Multiplier”.
 Shown as : 1/LRR
 Hence, credit flow remains unchanged and
unaffected.