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Credit Creation by Commercial Banks

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Topics

Estimated time: 25 minutes
  • Introduction
  • Definition: Credit Creation by Commercial Banks
  • Deposit Multiplier Formula
  • Methods of Credit Creation
  • Process of Credit Creation
  • Tabular Representation
  • Mechanism of Credit Creation
  • Limitations of Credit Creation
  • Assumptions
  • Steps of Creation
  • Key Points: Credit Creation by Commercial Banks
CISCE: Class 12

Introduction

Commercial banks are unique financial institutions because they can create the money supply by issuing deposits. While they cannot print physical currency, they increase the total money supply through the process of Credit Creation. This is a function exclusive to commercial banks; no other financial institution possesses this power.

CISCE: Class 12

Definition: Credit Creation by Commercial Banks

  • “Credit may be defined as the right to receive payment or the obligation to make payment on demand or at some future time on account of an immediate transfer of goods.” — Prof. R.P. Kant
  • “Commercial banks are the manufacturers of money.” — Prof. Sayers
CISCE: Class 12

Deposit Multiplier Formula

\[\text{Increase in Deposits}=\frac{1}{RR}\times\Delta D\]

where RR is the required reserve ratio, and ΔD is the initial change in the volume of deposits.
In our example,

New Deposits = `1/(20%)`× 1000

              = `1/(20/100)` ×1000

              = `100/20` × 1000
              = ₹5,000

CISCE: Class 12

Methods of Credit Creation

The heart of credit creation lies in the distinction between two types of deposits:

  1. Primary Deposits: These occur when customers deposit physical cash into the bank. The bank plays a passive role here. This merely converts currency into money held as deposits without changing the total money supply.
  2. Derivative Deposits: These are created when banks grant loans or purchase assets. Instead of giving cash to a borrower, the bank opens a current account in the borrower's name and credits it. This actively increases the total money supply.

Key Insight: Credit creation is essentially the process of creating derivative deposits. As the saying goes, "Loans create deposits."

CISCE: Class 12

Process of Credit Creation

Credit creation works through a multiple-banking system, where the loans of one bank become the deposits of another.

  • Initial Deposit: A customer deposits cash (e.g., ₹1,000) into Bank A.
  • Maintaining Reserves: The bank holds a fraction (e.g., 20%) of its deposits as a Cash Reserve Ratio (CRR) to meet potential withdrawals.
  • Lending Excess: The remaining 80% (₹800) is lent out.
  • Redeposit: The borrower spends that ₹800, and the recipient deposits it into Bank B.
  • Repetition: Bank B keeps 20% of the new deposit (₹160) and lends the rest (₹640). This continues until the initial ₹1,000 has grown into a much larger deposit total (₹5,000).
CISCE: Class 12

Tabular Representation

Bank (Round) Increase in Deposits (₹) Increase in Cash Reserves (₹) Increase in Loans (₹)
Bank of Baroda (1st Round) 1,000 200 800
Union Bank of India (2nd Round) 800 160 640
ICICI Bank (3rd Round) 640 128 512
Fourth Round 512 102.4 409.6
... ... ... ...
Total 5,000 1,000 4,000
CISCE: Class 12

Mechanism of Credit Creation

To understand the mechanism of credit creation, it is pertinent to introduce the T-Account.

T. ACCOUNT

A T-account is a short form of the balance sheet. It records the changes to the balance sheet over a specified period. Therefore, it may be used to show a simple transaction in a bank's books. Suppose a sum of ₹ 10,000 is deposited in a commercial bank. The bank's assets will increase by ₹ 10,000, and deposits will also increase by an equal amount.
This can be shown using the following transaction.

Δ Liabilities                                           Δ Assets
Demand Deposit +                                Value cash +
₹10,000                                                 ₹10,000

CISCE: Class 12

Limitations of Credit Creation

  • Total Availability of Cash: The "raw material" for credit. Banks can only create credit if they have primary cash deposits. If the Central Bank reduces the money in circulation, the "fuel" for credit creation dries up.
  • Cash Reserve Ratio (CRR): This is the legal "speed limit." The higher the percentage of cash a bank must keep in its vault (or with the Central Bank), the less money is left over to lend out.
    High CRR = Low Credit Creation.
    Low CRR = High Credit Creation.
  • Banking Habits of the People: Credit creation relies on money staying inside the banking system.
    If people prefer using cheques and digital transfers, the money flows from one bank account to another, allowing the multiplier effect to work.
    If people prefer to hold physical cash (leaking money out of the system), banks have fewer reserves to lend.
  • Public Confidence: Banking is built on "promises to pay." If the public loses trust in a bank's stability, they will withdraw their deposits. Without deposits, the bank’s ability to create credit vanishes instantly.
  • Nature of the Process (Collateral): Banks do not create money "out of thin air." They require valuable collateral (such as property, stocks, or bonds) to back a loan. If there are no borrowers with good security, no credit can be created.
  • Monetary Policy of the Central Bank: The Central Bank acts as the "Traffic Controller." It uses tools like:
    Bank Rate: Raising interest rates to make borrowing expensive (slowing down credit).
    Open Market Operations: Buying or selling government bonds to change the amount of cash available to banks.
CISCE: Class 12

Assumptions

For the credit creation model to work perfectly in theory, we assume:

  • Full Utilisation: Banks lend out all excess reserves (they don't keep idle cash).
  • Fixed Reserve Ratio: The cash reserve ratio (e.g., 20%) stays constant.
  • No Currency Leakage: All money stays in the banking system. When someone gets a loan, they spend it, and the recipient deposits it right back into a bank (no one hides cash under their mattress!).
  • Time Deposits Unchanged: Only demand deposits (current accounts) are considered.
CISCE: Class 12

Steps of Creation

Credit Creation by a Single Bank: In a single-banking system, only a single bank operates, and all cash deposits must be made to that bank. The credit creation by a single banking system can be illustrated with the following example.
Suppose the minimum cash reserve ratio maintained by the bank is 10 per cent. Let us suppose that a person deposits ₹ 20,000 in the State Bank of India.

The balance sheet of the bank will be:

STATE BANK OF INDIA

1st Round
Liabilities                           Cash Reserves                           Derivative Deposits
                                              r = 20%                                    ΔD
Primary deposits
₹20,000                                 ₹4,000                                       ₹16,000

Since the minimum cash reserve ratio is 20 per cent, the bank, after keeping ₹ 4,000 as cash reserve, will create a derivative deposit of ₹ 16,000, as it represents the excess reserves with the bank.

The balance sheet of the bank will be:

State Bank of India

Liabilities                                      Cash Reserves                  Derivative Deposits
Primary Deposit
20,000                                                    4,000                                  16,000
Derivative Deposit
16,000                                                       _                                      16,000
Second Round

Now, let us assume that the borrower A, upon repayment of a business obligation, issues cheques totalling ₹ 16,000 to a person who has a deposit account with the Syndicate Bank. This amount will increase the liabilities of the Syndicate Bank. Now, the bank, after keeping the cash reserve of 20 per cent of ₹ 16,000, will lend to others.

The balance sheet would be:

Syndicate Bank

Liabilities Cash Reserves Derivative Deposits
₹ 16,000 ₹ 3,200 ₹ 12,800

Again, the borrower B pays ₹ 12,800 to C, who has the deposit account in the Central Bank of India. As above, the central bank, after keeping a certain percentage as cash reserves, advances the remaining amount to someone else.

The balance sheet of the bank will take the form:

Central Bank of India

Liabilities Cash Reserves Derivative Deposits
₹ 12,800 ₹ 2,560 ₹ 10,240

The above table shows that the Central Bank has excess resources of ₹ 10,240, which it can utilise as a loan to its customers. This will create derivative deposits totalling ₹ 8,192.
In short, we can say that the process of multiple credit creation will continue till the initial primary deposits of ₹ 20,000 with the State Bank of India will lead to the total deposits of ₹ 48,000 and the initial cash reserves of ₹ 4,000 with the State Bank of India will lead to multiple expansion of total derivative deposits of ₹ 3,940 in the entire banking system.

CISCE: Class 12

Key Points: Credit Creation by Commercial Banks

  • Unique Money Creators: Commercial banks are the only financial institutions that can create "deposit money." They don't just lend existing cash; they expand the total money supply.
  • Primary vs. Derivative Deposits:
    Primary: Passive cash deposits by the public (doesn't change total money supply).
    Derivative: Active deposits created by banks through loans (increases total money supply).
  • The "Loans Create Deposits" Rule: When a bank grants a loan, it doesn't usually hand over cash. Instead, it opens a current account for the borrower, thereby "creating" a new deposit.
  • Fractional Reserve Requirement: Banks only keep a small percentage of deposits as cash (the Cash Reserve Ratio) because they know from experience that not all depositors will withdraw their money at the exact same time.
  • The Multiplier Effect: Through a chain reaction where one bank's loan becomes another bank's deposit, the banking system as a whole can create total deposits that are multiple times the original cash deposit.
  • Critical Limitations: The process isn't infinite. It is limited by the amount of available cash, the Central Bank's policy (interest rates/reserves), public trust, and collateral (securities).

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