Mechanism / Technique of Credit Creation by Commercial Banks

Mechanism / Technique of Credit Creation by Commercial Banks

Bank credit refers to bank loans and advances. Money is said to be created when the banks, through their lending activities, make a net addition to the total supply of money in the economy. Likewise, money is said to be destroyed when the loans are repaid by the borrowers to the banks and consequently the credit already created by the banks is wiped out in the process.

Banks have the power to expand or contract demand deposits and they exercise this power through granting more or less loans and advances and acquiring other assets. This power of commercial bank to create deposits through expanding their loans and advances is known as credit creation.

Primary / Passive Deposit and Derived / Active Deposit

The modern banks create deposits in two ways. They are primary deposit and derived deposit. When a customer gives cash to the bank and the bank creates a book debt in his name called a deposit, it is known as a “primary deposit’. But when such a deposit is created, without there being any prior payment of equivalent cash to the bank, it is called a ‘derived deposit’.

Primary Deposits

It is out of these primary deposits that the bank makes loans and advances to its customers.

The initiative is taken by the customers themselves. In this case, the role of the bank is passive.

So these deposits are also called “Passive deposits”.

Credit Creation literally means the multiplication of loans and advances. Every loan creates its own deposits. Central Bank insists the banks to maintain a ratio between the total deposits they create and the cash in their possession.

For the purpose of understanding, it is assumed that all banks are obliged to keep the ratio between cash and its deposits at a minimum of 20 percent.

1. The banks do not keep any excess reserves, in other words, it would exhaust possible avenues of income earning activities like giving loans etc. up to the maximum extent after attaining the minimum cash reserves.

2. There are no drains in the supply of money i,e., the public do not suddenly want to hold more ideal currency or withdraw from the time deposits.

Under the above assumptions, when a customer deposits a sum of ₹1000 in a bank, the bank creates a deposit of ₹ 1000 in his favor. Bank deposits (Bank Money) have increased by ₹1000. But, at this stage, there is no increase in the total supply of money with the public, because the above extra bank money of ₹1000 is offset by the cash of ₹1000 deposited in the bank.

The bank has now additional cash of ₹1000 in its custody. Since it is required to keep only a cash reserve of 20 per cent, this means that ₹ 800 is excess cash reserve with it. According to the above assumption, the bank should lend out this ₹ 800 to the public. Suppose, it does so, and the debtor deposits the money in his own account with another bank B, Bank is creating a deposit of ₹ 800. Bank B then has also excess cash reserve of 640(800-160). It could, in its turn, lend out ₹ 640. This ₹ 640 will, in its turn find its way with, say Bank C; it will create a deposit of ₹ 640and so on.

The total deposits will now grow into 1000+800+640+…….till ultimately the excess cash reserve peters out. It can be shown that when that stage is reached the total of the above will be ₹ 5000.

Money Multiplier = 1/20% =1/20/100=1/20x100=5 Credit creation is 1000x5 = ₹ 5000.