Name: Aakash Todi

Course: Level 4 BABM6

Student ID: st20132108

Subject: Money banking and risk

Module Leader: Prof. KV Ramkrishnan

Topic: Credit Creation

 Introduction and meaning of Credit Creation

Credit creation means creation of money by banks. It is one of the most

important features of the commercial banks. Creation of credit by modern
bank is the most outstanding function bank has. Bank is also regarded as
credit manufacture. Process of bank must be understood in monetary
terms, that is continuously withdrawal and deposits in bank. The money
received by the bank from depositors for a given period is advanced to
others in form of loan. What bank does is, they take out some fraction of
reserve from the money deposited, as they know that not every depositor
will come at the same time. Also these deposits have time period to be
matured, until bank can advance it as loan.

Credit money is based on bank deposits. There are two methods to create
credits through types of deposit, they are

1. Passive deposit
2. Active deposit

A passive deposit is opened when it is opened in the name of the

customer, who submits cash and cheque that are to be credited in their
account. These types of deposits are said to be passive deposits in
economic terms. These deposits are also called cash deposits or primary
deposit. From these deposits bank advances loan to its customers.
Keeping money in the bank vaults does not mint money for the bank, so
what they do is to loan out some amount of money from the primary
deposits and keeping rest as cash reserve, in case any depositor comes
and asks for money. By the experience in business bank knows that all
primary depositor will not withdraw its money at the same time, only few
of them might withdraw so to attain that they keep reserves. Primary
deposits are the major funds that bank uses to advance loan to customers.
Passive deposit does not lead to increase in supply of money. (Economics
Discussion, 2018)

An active deposit arises due to granting of loan or purchase of

government securities or when a bank discounts a bill. Arise of deposits
with the help of purchase of assets by a bank or granting loan are called
derivative deposits, which is another name for active deposits. As the
banker has an active role to play in creation of these deposits these are
called active deposits. A banker when advances or grants loan to a
customer, what it does is open a account in the name of the customer and
transfers the loan amount to that account. Later the customer can
withdraw all money from its account at once or in parts according to his
needs. Bank does not pay customers in cash. The customer to withdraw
the money can use cheques. It is said derivative deposit because it is
derived from the loan transaction of bank. (Economics Discussion, 2018)

Deposit or credit are not only created through granting of loans, it also
arise when a bank purchase government securities and discounting of
bill. The account of government is credited with purchase price of the
government securities, as when bank buys government securities they do
not pay purchase price at once in cash.
Government is free to withdraw anytime. Similarly in the case of bill
exchange, where a bank purchases the bill of exchange, it is credited to
the account of the seller and they promise to pay whenever he wants.

Analyse the need for Credit Creation

It is the most important part of an economy. It is a transaction between

lender and borrower, in which borrower promises to pay later with
interest. Credit creation is important due to following reasons:

 Growth of GDP in country

Due to availability of credit, it allows more people increase there

expenditure. Which in turn leads to increase in spending thus making
income level higher. This in turn will lead to faster productivity growth
and higher GDP. (Marketrealist.com, 2018)

 More business opportunity

Due to credit creation in an economy it allows people to take loan easily

from the bank. With the help of credit creation banks are creating more
loan to provide to an individual for business. This has led to increase in
more business opportunities and growth of business. If until today there
was no credit creation then business might not have prospered so much.
It helps people to invest in other business, helps in diversification.
 Economic growth

Making credit available to people in an economy leads to increase in

consumption and expenditure pattern of a consumer. Due to the process
of credit creation people are advanced loans for their work and which
they spend. This way national income has also rise in the economy.
Overall growth has also been seen in the economy after the credit
creation.

 Impact on banks

Banks are the major players getting impact by the credit creation. It is
because with the help of credit creation they provide loan to customers in
return for interest payments. When customer is willing to spend, credit
will grow. Banks will receive more interest as many loan they will
provide.

Here in graph we can see that how US banks have rise by Low interest
rate. Year by year credit has grown to 7.02% in 2015. Which more than
average of 2013 at the rate 6.33%.
(Marketrealist.com, 2018)

(Marketrealist.com, 2018)
Critically analyse Credit Creation cycle-the
process of Credit Creation-Numerical Illustration.
Multi expansion of credit is the important factor of credit creation
functions of commercial banks. Credit created by the banking system,
which is several times more than the original increase in deposit of bank.
This process is called multiple creation of credit or multiple expansions.
Multiple contraction of credit leads when withdrawal is made from any of
the bank. The process of multiple credit creation can be shown by an
example,

 The numbers of banks are M, N, R etc. Each with different sets of

depositors.
 Every bank has to keep 20% of cash reserve as securities according
to the law.
 Bank M has received deposits of Rs 100, to start with

Assuming a person approaches to bank and deposit Rs 100 cash in bank

M. Now bank M deposits are increased by Rs 100 and cash account also
by 100.

The balance sheet of M is following:

BALANCE SHEET OF BANK M

Liabilities Assets

Primary deposits 100 Cash 100

Total 100 Total 100

According to the double entry book keeping system Rs 100 will shown on
both sides.
The Rs 100 is both a liability and asset to bank M. According to bank law,
bank M has to maintain 20% as cash reserves. It means 20% of Rs 100
that is Rs 20.against the deposit and the other Rs 80 can be used as
advance to loan to other.
We assume that bank M gives loan to Y, which he uses pay off his sundry
creditors.

BALANCE SHEET OF BANK M

Liabilities Assets

Primary deposits 100 Cash 20

Loan to Y 80
Total 100 Total 100

(Cms.gcg11.ac.in, 2018)

Now Y purchases good from Z of Rs 80 and pays cash to him. Z deposits

the amount to bank N. Now bank N has increased its deposits by Rs 80
and cash in hand also increases by Rs 80. Now according to the law bank
N also keeps reserve of 20%, which is Rs 16. Bank N is now free to avail
loan of Rs 64 to anyone. Now he lends money to X, who uses it to pay off
its creditors.

BALANCE SHEET OF BANK N

Liabilities Assets

Primary deposits 80 Cash 16

Loan to X 64
Total 80 Total 80
(Cms.gcg11.ac.in, 2018)

Now X purchases good for Rs 64 from S and Pays him in cash. And S
deposits the amount i.e. Rs 64 in the bank R. Bank R now has deposits
increased by Rs 64 and also has increased there cash in hand by Rs 64.
Bank R has to maintain reserve that will be around Rs 12.80 and bank R
would have Rs 51.20 for advance of loan to others. Bank R lends Rs 51.20
to some merchant. This process goes on till the nth number then
Multiple deposit expansion process

Bank Acquired Required Excess reserves New created

reserves and reserves money
deposits
M 100 20 80 80
N 80 16 64 64
R 64 12.80 51.20 51.20
A 51.20 10.24 40.96 40.96
B 40.96 8.19 32.77 32.77
C 32.77 6.55 26.22 26.22
D 26.22 5.24 20.98 20.98
E 20.98 4.20 16.78 16.78
F 16.78 3.36 13.42 13.42
G 13.42 2.68 10.74 10.74
H 10.74 2.15 8.59 8.59
I 8.59 1.72 6.87 6.87
J 6.87 1.37 5.50 5.50
K 5.50 1.10 4.40 4.40
Other banks 21.97 4.40 17.57 17.57
TOTAL amount of money created by the banking system 400
(Cms.gcg11.ac.in, 2018)

The table above shows the following details

Cash reserve ratio also know as CRR is 20% and the initial deposit is Rs
100 then

The money creation or newly created money by bank is of Rs 400.

Total demand deposit is Rs 500 initial deposit + credit creation (100 +

400 = 500).
It is clear from the above that out of initial primary deposit or passive
deposit bank M advance Rs 80 as a loan. Then which turn to be forming
the passive deposit of bank N as Rs 64. This sum again formed the passive
deposit of Rs 51.20, which in turn was again advanced to loan to others.
Rs 100 deposit resulted in bank credit of Rs 195.2.

Many banks process will come to an end when no bank has excess funds
to lend. This will lead to end of credit expansion. If the cash ratio is 10%
then there will be 10-fold increase, if the cash ratio is 20% then there will
be 5-fold increase. During the increase in deposits bank will face multiple
expansion of credit. While during loosing of cash they will face multiple
contraction of credit.

With help of money multiplier a bank can found till what extent it can
create credit. That is

K = 1/r

Where here k is the money multiplier and r is the reserve ratio. So

therefore applying from above will get
K = 1/0.20
K=5

This shows that banking system can create five times more than
originally increase in deposit. It is seen that size of credit multiplier is
inverse to percentage of cash reserve the bank have maintained. If
reserve ratio decreases money multiplier will increase and if it increases
then money multiplier will decrease.
Critically analyse the limitations of Credit
Creation

1. Amount of cash
Amounts of cash with bank affect the credit creation. Higher the cash
commercial bank has, more will be credit creation. But the amount to be
holding by commercial bank is in hands of central bank. By purchasing
government securities or selling government securities central bank can
lead to expansion or contraction cash.
Moreover it depends on increase or decrease of CRR.

2. CRR
CRR can be referred as cash reserve ratio, which means a part of deposit
banks has to maintain with central bank. All the deposit which have been
received by the bank cannot be used for credit creation. Some of its
percentage bank has to keep with central bank. The credit creation by
bank depends on the CRR ratio, if the ratio is more than the bank will not
be able to create more credit but if it is less than it will allow to create
more credit for bank. Cash reserve ratio is maintained by central bank, it
has power to change the ratio for the commercial bank. Central bank
mainly uses this technique during inflation and deflation. Where they
increase CRR rate during the time of inflation so that banks have less
money to lend it to customers and during deflation they lowered the CRR
rate so that bank can avail more and more loans to the customers.
(Economics Discussion, 2018)

3. Leakages in credit creation

There may be leakages in credit creation due cash idle kept by people at
home or non-transferring of funds smoothly from one bank to another.
These could create leakages in credit creation. There are different types
of leakages:

a) Excess reserves

During recessions bank decide to maintain more reserves instead of using

funds for granting loans. So in such situation credit creation will be
smaller as a large amount of cash being reserved.
b) Currency drains

When people does not deposit their money to the bank and holds cash
with them which affects the credit creation of a bank, as if there will no
deposit then how will bank will generate credit. No deposit will leads to
no loan grant.

4. Banking habits of people

A multiple expansion of credit can only be when loan advances to people
or customer will come back in to the bank again as primary deposit. This
process will only happen when banking habits of people will remain same
and developed. Using cheques for withdrawal or payment and depositing
their money in the bank.

5. Nature of business condition in the economy

Credit creation will totally be dependent on the nature of business

condition in the economy. The nature of business could be either
prosperity period or depression period. During the time of prosperity
there would be more customer who will want loan for growth and
prosperity. So there will be more loan advances for investment purpose,
hence during that time bank will want to keep its credit high. But during
the time of recession people and industrialist may not borrow the money.
Hence during that time bank credit will be Low. (Economics Discussion, 2018)

6. Sound securities
Crowther says, " Banks cannot create money out of thin air. It transmutes
other forms of wealth into money". By acquiring sound and profitable
assets like discounting bills and government securities, bank creates
credit. If customer cannot offer sound or good assets and government
bonds then they may not be able to create credit.
7. Liquidity preferences
It all resides in the hands of people, either they will deposit or they will
keep cash idle. Therefore if people do not prefer to deposit it in bank then
bank will not be able to create credit. This will lead to reduce in credit
creation power of bank.

8. Monetary policy of The Central bank

The credit creation by the commercial bank will be totally depend on the
monetary policy forced by The Central bank to commercial bank of the
country. The ultimate power for creation of credit lies with central bank.
They monitor all the money supply in the economy. If they want that
credit creation of banks should made lower then they will raise cash
reserve ratio. Which will make fall power of banks to create credit.
There are certain weapons available with central bank like bank rate,
open market operation with the help of which it can control the
expansion and the contraction of credit creation.

These are the limitations, which bank face during credit creation.
Business activity is lot helped by these function credit creation. It helps
business to grow. Overall we should not forget the importance of credit
creation and its impact on the economy. Bank credit is the Oil, which
lubricates the wheels of the business.
Critically examine the Economic and legal
aspects of Credit Creation

Economic aspects

Credit creation in an economy is controlled by central bank. Central bank

is the head of all other bank. Banking and financial institutions are been
monitored by central bank. With the help of its monetary policy it sets
down a reserve requirement for the commercial banks. These reserves
are made in order to maintain/controlling credit and liquidity in the
economy. During the period of Low growth in the economy or during the
depression prices for all things goes down. Since the depression in the
economy is not desirable The Central bank lowers the CRR rate so that
now banks would be able to create more credit therefore more loans to
advance at lower borrowing interest. This way business will be able to
borrow loan at lower rate and hence economy will rise from depression.
When in an economy during high period of prosperity, prices shoots up
and shoots inflation up too. Since such a high inflation will lead to
problems in an economy, so central bank increases the CRR rate so that
banks would not be able to create enough credit for what people are
demanding. They will break the supply of credit and hence when it is
done it will make interest rate higher for the borrower. It will lead to
reduction in borrowing and consequently reduced in growth. Which in
turn will help in reduction of inflation.

Thus, reserve requirements actually influences credit growth. Formula

for it is as follows

Money supply growth 1

Reserve ratio
Legal aspect

Credit creation for bank is profitable. Central bank controls it by lowering

or making higher the CRR rate. If banks do not follow the rules and
regulations laid by the Central bank they are been punished. There may
be times when banks have been breaking rules and they have been
penalized according to RBI act and banking relation act.

Penalty for not maintaining CRR according to central bank will lead to
Penalty for CRR Bank rate + 5%

Penalty for not maintaining SLR according to central bank will lead to
Penalty for SLR Bank rate + 3%

It is important that bank should not break rules laid by the Central banks
because central bank Lays these rule to control credit creation, which is
for welfare of economy.
Conclusion

Credit creation is the most important feature of the commercial bank.

From the above answers, undoubtedly, we can say that, commercial
banks form the most important part of financial intermediaries. Bank
accepts deposits from the people and advances loan from it, if these credit
creation function would not have been there than country would haven't
faced so much growth. Credit creation is the reason of the growth of the
country. Banks are the significant part of infrastructural essentials for
breaking vicious circle of poverty and economic growth. Central bank also
plays a vital role in the credit creation function. It is the main power to
control banks credit creation.

If there would have been no credit creation then there would be no

economic growth in the country, there may not much business
opportunities what we have today. It also has it con and pros but they
have been maintained by central bank. Lastly I would conclude that credit
creation is important for the economy.
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