Credit creation is a situation in which banks gives more loans to consumers and businesses, with the result that the amount of money in circulation increases. In other words, it refers to the unique power of the banks to multiply loans and advances and hence create credit on the basis of primary deposit of account holders.
Following are the methods of credit creation :
(i) By issuing notes
(ii) By accepting deposits
(iii) By discounting the bills of exchange
(i) By issuing notes : In modem times, the issue of currency in most of the countries is done by the central bank of the country. In India, Reserve Bank of India performs the task of issuing notes. For this purpose, RBI uses minimum reserve system. This is called credit creation by the central bank.
(ii) By accepting deposits : Prof. Honum has divided the deposits into two parts –
(a) Primary deposits
(b) Derived deposits
(a) Primary deposits : Primary deposits are those deposits that a bank collects from different surplus stakeholders in the economy by different accounts. These consist of cash deposited by the people with the banks in different deposit accounts, such as saving deposits, time or fixed deposits, current or demand deposits and other deposits. The depositors themself take the initiative of creation of these deposits.
(b) Derived deposits : Deposits created from different underlying transactions of bank are called derivative deposits. The prime underlying transaction includes, granting credit to clients in various forms. Therefore the banks, in the process of granting credit, create derivative deposits. The loans are sanctioned and credited to the accounts of the borrowers to create new deposits. Thus, it is true to say that “deposits create loans and loans create derived deposits”.
(iii) By discounting bills of exchange : Banks also create credit by discounting bills of exchange like foreign exchange, sale and purchase of foreign securities, etc :
Explanation of creation of credit through an example : Assume that an intial deposit of Rs. 20,000 is made in a commercial bank. If the bank’s cash reserve ratio is 20% then according to the loan provision, the bank can keep 20% of its initial deposit (Rs.4000) aside and can sanction the balance amount (Rs. 16000) as loan. This amount of Rs. 16000 would not be given as cash to the lender but would be deposited in his account. The person can withdraw the amount since bank knows that a person is allowed to withdraw only 20% the amount at a time. (If the bank issues a loan of Rs. 16000 to an individual, the credit deposited can again be given in the form of loan). In this way, every loan gives rise to deposits. Therefore, the bank would keep the remaining amount of (16000 × 20%) ie. Rs. 3,200, and the rest of the amount ie Rs. 12,800 would again be provided as loan.
Limitations of Credit Creation :
1. Development of Banking – Credit creation is more, where development is more. And, the credit creation is lesser, where development of banking is lesser.
2. Habit of Banking – The country, whose people use more banking facilities, credit creation is more used there.
3. Industrial and Business development – The country, where industries and business are more developed, credit creation is more.
4. The Monetary Policy of Central Bank – The Monetary Policy of Central Bank also affects credit creation. Flexible and liberal Monetary Policy promotes credit creation, while rigid monetary policy, keeps it lagging.
It is clear from the given example, that how commercial banks create credit through deposits. How much cash would be created is defined through the cash fund ratio. According to this example, if the cash fund ratio is 20%, then cash creation would be Rs. 8000.
Credit creation visualizes a descent format. It is based on the following assumptions –
- A cheque received from a bank can be deposited in some other bank.
- The cash fund ratio of the bank remains stagnant.
- People ask for the loan till the maximum loan providing limit of the bank is reached.
- Banks also try to provide the loans till their maximum limit is reached.
