Credit Creation Process of Commercial Banks and its Limitations

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CREDIT CREATION PROCESS OF COMMERCIAL BANKS AND ITS LIMITATIONS

The commercial banks perform a no. of functions. Among these, credit creation is quite important. The power of Commercial Banks to expand deposit through expanding their loans and advances is known as credit creation .

It is true that bank cannot lend more than what it has got but it is also true that what is lent out by a bank may come back to the same bank.  By way of new deposits which may again be lent out and soon deposit becoming the basis for a loan or investments, which again return to the bank as fresh deposit becoming the basis for a new loan on so on. A modern bank creates deposits in two ways .

Firstly, in a passive way which results in primary or passive deposits

Secondly, in a more action way which results in active or derivative deposits.The process of credit creation by commercial banks is explained as follows: (with the help of an example).

Suppose ‘A’ deposit Rs. 10,000 in a bank X, which is the primary deposit of the bank. The cash reserve requirement of the Central Bank is 10%. Then, bank X will keep Rs. 1000 as reserve with the Central Bank and will lend remaining Rs. 9000 to needy borrowers.In other words, the bank X does not give B cash while sanctioning the loan. Instead the bank merely opens a loan account in the name of B and credits to his account Rs. 9000. Then B pays to C, to whom he owes Rs. 9000, by way of cheque to settle his account with C.

C now deposits the cheque of Rs. 9000 in Y bank. The bank Y, after keeping a sum of Rs. 900 as CRR requirement of the Central Bank, lends Rs. 8100 to another borrower D. Thus, this process of deposits and credit creation continues till the reserves with commercial banks becomes zero.

Hence, the bank gets new deposit from the loan given and actively creates this new deposit. Thats is why it is always said that loans create deposits. The new deposit created in this manner will add to the money stock of the economy. Whenever the loan is returned by the borrower to the bank, then there is no further possibility of creating new deposit. This results in net decrease in money stock

LIMITATIONS OF CREDIT CREATION

1. Amount of Cash:

The first Important factor on which the extent of credit creation depends is the amount of  cash. Which commercial banks possess. The larger the amount of cash which C.B possesses, the larger the amount of cash with the banking system, the greater  will be the excess funds hence larger will be the credit creation by the bank.

If the volume of currency in circulation increases, the volume of primary deposits will also increase, enabling the Commercial Banks to create a larger volume of derivative deposits.

2. Cash reserve rate :

 If banks have to keep small amounts in the form of cash reserves , their power to create credit will be more. The larger the ratio of cash reserves to the total deposits, the lesser will be the power of the banks to credit. In sum, credit creation is the reciprocal of the C R. Ratio.

3. External Drain:

The external drain refers to cash withdrawal from the banks by the borrowed. The C.B expands their credit creation on the basis of the excess reserves with them.

Some of the borrowers from the bank are likely to withdraw part of their deposits in currency.  Every rupee in cash that is withdrawn from the banking system lowers the reserves of the bank and thus checks further  deposit expansion.

4. Business Condition:

During the period of business prosperity, demand for loans & advances by the business community is more. Therefore the power of the banks to create credit will increase. Likewise during depression , the demand for loans & advances is less the reform the credit creation power of the banks also diminishes.

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