Question

How do commercial banks create credit?

How do commercial banks create credit? Explain with the help of an example.

How is credit created by a Commercial Bank? Explain with example.

Answer 1

Commercial banks create credit by accepting deposits from the public and lending a major portion of these deposits to borrowers. When a person deposits money in a bank, it is known as a primary deposit. Banks are required to keep a small portion of these deposits as reserves (called the Cash Reserve Ratio or CRR) to meet withdrawal demands, while the rest is used for lending. The money lent to borrowers usually comes back into the banking system as new deposits, either through spending or saving, thereby creating derivative deposits. This process continues multiple times, leading to the creation of a much larger amount of total deposits compared to the initial cash reserve. The total credit created depends on the cash reserve ratio; a lower reserve requirement allows a higher multiple of credit creation. However, credit creation is limited by factors such as legal restrictions, cash reserve needs, economic conditions, and the public’s demand for loans. Thus, commercial banks play a key role in expanding the money supply and supporting economic growth by creating credit.

For example, suppose a person deposits ₹ 10,000 in a bank. If the Cash Reserve Ratio (CRR) is 10%, the bank will keep ₹ 1,000 as reserve and lend ₹ 9,000 to a borrower. The borrower may use this ₹ 9,000 to make purchases, and the seller who receives the money will again deposit it in a bank. Now, the bank will keep ₹ 900 (10% of ₹ 9,000) as reserve and lend ₹ 8,100 further. This process continues and leads to multiple expansions of deposits and credit in the banking system.

However, credit creation is limited by factors such as legal restrictions, cash reserve needs, economic conditions, and the public’s demand for loans. Thus, commercial banks play a key role in expanding the money supply and supporting economic growth by creating credit.