Banking 17 Question #06 Define credit creation, Explain its process and limitation. OR Deposit creates loans and loans create deposits. Explain OR Bank is the manufacture of Credit. Discuss. Introduction One of the important functions of commercial bank is the creation of credit. Credit creation is the multiple expansions of banks demand deposits. Definition Credit creation refers to the power of commercial banks to expand secondary deposits either through the process of making loans or through investment in securities." Explanation Bank credit means bank loans and advances. A bank keeps a certain proportion of its deposits as minimum reserve for meeting the demand of the depositors and lends out the remaining excess reserve to eam income. The bank loan is not paid directly to the borrower but is only credited hi his account. Thus, credit creation means multiple expansions of bank deposits. The word ‘creation’ refers to the ability of the bank to expand deposits as a multiple of its reserves. Basis of Credit Creation Primary Deposits ‘When a person deposits some money in the commercial bank, the bank opens account in the name of that person. The depositor is given the cheque book. Now he can withdraw his amount from his account by drawing cheques on the bank. The account so opened by the bank or the deposit so created is called the primary deposit. Secondary Deposits However, when a bank advances a loan, it opens the account in the name of the borrower and the borrower is given a right to draw cheques on the bank. The account so opened or the deposit so made is called the secondary deposit. Reserves All the commercial banks are required to keep certain amount of cash with the central bank. Such cash Kept with the central bank is called reserve. It is a legal binding on the commercial banks to hold certain reserve with the central bank. The basic reason behind it is the control and dominance of the central bank, Reserve Ratio ‘The amount of such reserve is calculated on the basis of ratio called reserve ratio = Amount of reserve Resivemiy = ‘Commercial bank's demand deposit liabilities For example Suppose the bank has Rs. 100,000/- wouth of deposit abilities. Now if the reserve ratio is set at 20% then putting values in the above fomula; 20% = Amount of Reserves 100,000 20x 1,00,000 = Amount of Reserves 100 Amount of reserves. = Rs. 20,000 Jamshaid Iftikhar M. Phil Commerce & Finance ‘Cell No, 0330 —22 422 99Banki 18 In this case banks have to keep reserve worth Rs. 20,000 with the central bank. ASSUMPTIONS 1. All banks are required to hold 20% of the demand deposit liabilities as reserves with the central bank, 2. All payments and receipts are made through cheques, 3. Loan advanced by one bank is deposited by the borrower in his bank. 4. Normal circumstances are prevailing in the economy. There is neither too much nor too low credit. 5. No credit control policy is being acted upon by the central bank. 6. The amount taken by the customer, as loan from one bank must be deposited the same into second bank. PROCESS OF CREDIT CREATION ‘Stage 1: Bank balance sheet Bank - ABC [ Assets Liabilities Cash 150,000 | Capital 150,000 Stage-2: Accepting Deposits ‘A trader Mr. Asim, decides to deposit Rs, 1, 00,000 in the bank. He goes to the bank opens the accomnt in his name and deposits cash. At this stage balance sheet shall be like this Bank - ABC ‘Assets Liabilities Cash 250,000 | Capital 150,000 Demand deposit 100,000 All the banks are required to hold certain pere: Stage-3: Depositing Reserves with Central Bank entage of demand deposit liabilities as reserves with the central bank. We have assumed that this percentage is 20%, So bank deposited Rs. 20,000 reserves in the central bank. The balance sheet will now look like as follows: | Bank - ABC | Assets Liabilities Cash 230,000 | Capital 150,000 Reserve 20,000 | Demand deposit 100,000 Stage-4: Granting a Loan Suppose a business man Mr. Aftab contacts with the bank and submit an appli amounting to Rs. 80,000. After fulfilling all the procedure bank grants him th withdraws this loan, the balance sheet will be as follows: ication for getting a loan i¢ loan, When Mr. Aftab Bank - ABC Assets Liabilities ‘Cash 150,000 | Capital 150,000 Loan 80,000 | Demand deposit 100,000 Reserve 20,000 Jamshaid Iftikhar M. Phil Commerce & Finance ‘Cell No, 0330 —22 422 99Banki 19 Stage 5: Second Generation ‘We have assumed that loans advanced by one bank are deposited in other So suppose now that Mr. Afiab purchases a plot of land fiom Mr. Babar for Rs. 80,000. The deal between Mr. Aftab and Mr Babar have been finalized. Mr. Aftab withdraw the amount from ABC Bank aud hands it over to Mr. Babar. Mr. Babar deposits this money in the bank named XYZ Bank. Balance sheet of XYZ Bank before receiving deposit is as follows; [ Assets Liabilities Cash 500,000 | Capital 500,000 Mr. Babar deposit the money into his bank account. The balance sheet position of bank XYZ is as follows, Bank - XYZ. Assets Liabilities Cash 380,000 | Capital 500,000 Demand deposit 80,000 As we have assumed that reserves ratio is 20%. Bank has to keep 20% of demand deposits as reserve, The reserve amount will be Rs. 16,000. The position of balance sheet is as follows; Bank -XYZ Assets Liabilities Cash, 564,000 | Capital 500,000 Reserve 16,000 | Demand deposit 80,000 ‘Now the bank XYZ also receives an application fom Mr. Zafar. for loan Rs. 64,000. After fulfilling documentary requirement XYZ bank advances the loan to Mr. Zafar. The balance sheet will now be as follows: Bank -XYZ Assets Liabilities Cash 500,000 | Capital 500,000 Loan 64,000 | Demand deposit 80,000 Reserve 16,000 Stage-6: 3" Generation Mr Zafar use the loan maount Rs. 64,000 and deposited it to the EFG Bank. EFG bank also creates the reserve amount Rs, 64,000, which will be Rs. 12,800 (20% of Rs. 64,000) The process goes on like that but it eradnally diminishes and contracts in volume. The further generation can be analyzed with the help of the following table: S.No. | Banks _| Deposits Reserves | Loan ca ABC | 100,000 20,000 80000 2 XYZ 80,000 16,000 64,000 3 EFG 64,000 12,800 51,200 4_| Other Banks The table clearly shows that at each stage credit is created but of lesser than the previous value. The end of result of this series can be found with the help of a simple formula: ‘Maximum Demand Deposits = Initial Credit Created x Monetary Multiplier So: Monetary Multiplier = I/Required Reserve Ratio m = Ir Jamshaid Iftikhar M. Phil Commerce & Finance Cell No, 0330-22 422 99Banking 20 Reserve ratio is assumed 20%. So m 1/20% m = 0.05% = 5 Putting the value of multiplier in the above mentioned formula, we have Maximum Demand deposits = 80,000 x 5 = 4,00,000 The sum of column '3' above after all the calculation can be verified. This is how the bank create credit. LIMITATIONS ON THE PROCESS OF CREDIT CREATIO! Currency drains An assumption of our credit creation process is that all receipts and payments are macle by cheques. In reality this may not go like this. A borrower may wish to take cash instead of cheques. This will reduce the lending potential of the commercial banks. 2, Excess reserve It is our assumption that banks hold only 20% reserves and rest of the amount is disbursed as loan. However, iu reality no commercial bank works like that, Banks always teud to have huge reserves with, the central bank and with themselves also. 3. Primary Depositor: The credit creation process depends on the availability of primary deposits. If banks have adequate primary deposit only then they can create credit. There is a direct relation between primary deposits and credit creation, 4. Cash Reserves Ratio Banks always hold some percentage of their demand deposits as reserve with the central bauk. If this percentage or reserve ratio is high it will reduce the lending power of commercial banks. 5. Economic Circumstances ‘Commercial banks can't create credit on their own. They can only make it when borrowers demand loans. The economic circumstances and monetary situation affect the credit creation potential. 6. Monetary Policy The commercial banks are not independent to lend. The central bank of the country can impose certain restrictions on banks regarding the issuance of loans. Central bank control lending power of commercial through monetary policy tools such as bank rate, reserve ratio, open market operation. 7. Different Types of Deposits Commercial banks accept three main different types of deposits which are Demand Deposits, Savings Deposits, Fixed deposits. It is our assumption all deposits received by the banks are demand deposits. The reality is entiely different, Banks normally have greater portion of savings deposits, This factor also reduce the credit creation process. 8 Willingness to Borrow The commercial banks cannot create credit unless there is demand for loan from customers. If the people are not willing to borrow then credit cannot be created. CONCLUSION Tt-can be said that the credit creation process is a fascinating aspect of modem commercial banking, ‘Apart from this, it plays an important role in the modem economy. Jamshaid Iftikhar M. Phil Commerce & Finance ‘Cell No, 0330 —22 422 99