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.

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.