Credit creation

The commercial banks as the creators of bank credit influence significantly the community’s
money supply. And the money supply in an economy determined by deposits of commercial
banks. In the prospective banks have two types of deposits:
i) Primary deposits: The consist of cash deposits by the people with the banks in
different deposit accounts as saving, fixed, current and so on.
ii) Derivative deposits: These consist of deposits created by the banks in the process of
granting credit. The loan sanctioned and credited to the account of borrowers creates
new deposits. Thus it is true to say that,” Deposits create loans and loans create
deposits”.
Credit creation means that on the basis of primary deposits commercial banks make loans and
expand the money supply. It results in multiple expansions of banks demand deposits. It is an
open secret that banks advance a major portion of their deposits to the borrowers and keep
smaller part of them for the payment to the customers on demand. Even then the customers of the
banks have full confidence that their deposits lying in the banks are quit safe and can be
withdrawn on demand. The banks exploit this trust of the customers and expand loans several
times than the amount of demand deposits possessed by them.
This tendency on the part of the commercial banks to make loans several times of the excess
cash reserves kept by the bank is called creation of credit.

Process of Credit creation

A monopoly bank:
Assume that total legal lender money in circulation is Tk.1000 and there is only one bank. The
bank likes to keep a 20% cash reserve to meet the requirements of its depositors. The balance
sheet of the bank will appear as follows:
Balance sheet 1
Liabilities Tk. Assets Tk.
Deposits:
Primary 1000.00 Cash in hand 1000.00
Since the bank has to keep only 20% as cash reserve in advances Tk.800 to borrowers by
crediting their accounts with it. The balance sheet will now appear in follows:
Balance sheet 2
Liabilities Tk. Assets Tk.
Deposits:
Primary 1000.00 Cash in hand 1000.00
Derivative 800.00 Advances 800.00
Total 1800.00 Total 1800.00
The total deposits with the bank are now tk.1800. Since the bank has to keep only 20% as cash
reserve, it can advance further Tk. 640 by crediting the accounts of borrowers. The balance sheet
will now be as follows:
Balance sheet 3
Liabilities Tk. Assets Tk.
Deposits:
Primary 1000.00 Cash in hand 1000.00
Derivative (800+640) 1440.00 Advances 1440.00
Total 2440.00 Total 2440.00
Thus the bank has created a further deposit of Tk.1440 with a primary deposit of Tk.1000.
The banking system as a whole:
The underlying assumptions of this system are - the existence of a number of banks, A, B, C etc.
each with different sets of depositors & Every bank has to keep 20% of cash reserves, according
to law. Now, suppose a person deposits Tk. 1000 cash in Bank A. As a result, the deposits of
bank A increase by Tk. 1000 and cash also increases by Tk. 1000.

Balance sheet of Bank A

Liabilities Tk. Assets Tk.
Deposits 1000.00 Cash in hand 1000.00
Under the double entry system, the amount of Tk. 1000 is shown on both sides. The deposit of
Tk. 1000 is a liability for the bank and it is also anasset to the bank. Bank A has to keep only
20% cash reserve, i.e., Tk. 200 against its new deposit and it has a surplus of Tk. 800 which it
can profitably employ in the assets like loans. Suppose bank A gives a loan to X, by opening an
account in his name, known as demand deposit account. However, this is not actually paid out to
Mr. X. The bank has issued a check-book to Mr. X to withdraw money. Now, Mr. X writes a
check of Tk. 800 in favor of Mr. Y to settle his earlier debts. After the loan has been made and
the amount so withdrawn by X to pay off his creditors, the balance sheet of bank A will be as
follows:
Balance sheet of Bank A
Liabilities Tk. Assets Tk.
Cash in reserve 200
Deposits 1000.00 Loans & investment 800
Total 1000.00 Total 1000
The check is now deposited by Mr. Y in bank B. After keeping a cash reserve of 20%, Bank B is
free to lend the remaining balance to anyone. And this process will be continue until the excess
reserves of tk. 800 of the bank A were exhausted, we would find that the banking system had
been able to create tk. 4000 of new deposits in the process. It ends up with final bank deposits
with tk. 5000 and total reserves would be Tk. 1000.
Deposits creation by the banking system:
Reserve against new Deposits created on the basis
Banks New deposits received
deposits (20%) of excess reserve (80%)
A 1000 200 800
B 800 160 640
C 640 128 512
D 512 102.4 409.6
E 409.6 81.92 327.68
F 327.68 65.536 262.144
G 262.144 52.4288 209.7152
……… ……… ………… ………
Grand Total 5,000.00 1,000.00 4,000.00
Through the above mechanism commercial bank creates credit and also creates deposit. No
single bank in the banking system can create deposits to the multiple of excess reserves, but
working together banks as a whole.

Credit Multiplier
The credit multiplier is the reciprocal of the required reserve ratio.

Credit multiplier = 1/required reserve ratio Credit multiplier = 1/required reserve ratio
If reserve ratio is 20% If reserve ratio is 10%
Then credit multiplier = 1/0.20 = 5 Then credit multiplier = 1/0.10 = 10

Total deposits = 1000*1/20% = 5,000 Total deposits = 1000*1/10% = 10,000

Total reserves =200*1/20%=1,000

Total derivative deposits=800*1/20%=4,000

Thus, it can be inferred that lower the CRR, the higher will be the credit creation, whereas higher
the CRR, lesser will be the credit creation. With the help of credit creation process, money
multiplies in an economy. However, the credit creation process of commercial banks is not free
from limitations.
Some of the limitations of credit creation by commercial banks are shown in following
Figure:

The limitations of credit creation process (as shown in Figure-3) are explained as follows:

(a) Amount of Cash:

Affects the creation of credit by commercial banks higher the cash of commercial banks in the
form of public deposits, more will be the credit creation. However, the amount of cash to be held
by commercial banks is controlled by the central bank.
The central bank may expand or contract cash in commercial banks by purchasing or selling
government securities. Moreover, the credit creation capacity depends on the rate of increase or
decrease in CRR by the central bank.

(b) CRR:
CRR Refers to reserve ratio of cash that need to be kept with the central bank by commercial
banks. The main purpose of keeping this reserve is to fulfill the transactions needs of depositors
and to ensure safety and liquidity of commercial banks. In case the ratio falls, the credit creation
would be more and vice versa.

(c) Leakages:
Imply the outflow of cash. The credit creation process may suffer from leakages of cash.

The different types of leakages are discussed as follows:

(i) Excess Reserves:
Takes place generally when the economy is moving towards recession. In such a case, banks
may decide to maintain reserves instead of utilizing funds for lending. Therefore, in such
situations, credit created by commercial banks would be small as a large amount of cash is
resented.
(ii) Currency Drains:
Imply that the public does not deposit all the cash with it. The customers may hold the cash with
them which affects the credit creation by banks. Thus, the capacity of banks to create credit
reduces.

(d) Availability of Borrowers:

Affects the credit creation by banks. The credit is created by lending money in form of loans to
the borrowers. There will be no credit creation if there are no borrowers.
(e) Availability of Securities:
Refers to securities against which banks grant loan. Thus, availability of securities is necessary
for granting loan otherwise credit creation will not occur. According to Crowther, “the bank does
not create money out of thin air; it transmutes other forms of wealth into money.”

(f) Business Conditions:

Imply that credit creation is influenced by cyclical nature of an economy. For example, credit
creation would be small when the economy enters into the depression phase. This is because in
depression phase, businessmen do not prefer to invest in new projects. In the other hand, in
prosperity phase, businessmen approach banks for loans, which lead to credit creation.

In spite of its limitations, we can conclude that credit creation by commercial banks is a
significant source for generating income.

The essential conditions for creation of credit are as follows:

a. Accepting the fresh deposits from public
b. Willingness of banks to lend money
c. Willingness of borrowers to borrow.