Question

State various limitations on the power of credit control.

Answer 1

1. Policy of the Central Bank: The central bank has the ability to influence how much money commercial banks can create. Since banks are required to keep a portion of their deposits as reserves with the central bank, an increase in this reserve ratio limits their capacity to lend, reducing credit creation. Similarly, through open market operations, the central bank can change the amount of cash available with banks, thereby affecting their ability to extend credit.
2. Cash Reserve Ratio: The requirement to keep sufficient cash reserves puts a limit on how much credit banks can create. Banks must always ensure they have enough cash to meet customer withdrawals. It is considered a strict and essential rule by bankers to never let their cash reserves drop below a fixed percentage of total deposits.
3. Good Securities: Banks provide loans to customers based on reliable securities such as bills, shares, stocks, or bullion. The presence of such quality securities limits how much credit banks can create. If a borrower fails to repay, the bank should be able to convert the security into cash to recover the loan amount. As Crowther noted, banks do not create money from nothing; instead, they convert existing forms of wealth into money.
4. Willingness of Customers to Borrow: Even if banks are willing to offer loans, credit creation can only happen if customers are willing to borrow. During periods of economic prosperity, businesses actively seek loans. However, in times of recession or falling prices, they avoid borrowing despite the availability of credit. Therefore, the ability of banks to create credit largely depends on the demand for loans, which is influenced by overall business conditions.
5. Banking Habits of the People: When people frequently use cheques, banks can operate with lower cash reserves, as fewer withdrawals are made in cash. However, if the use of cheques is not common, banks are forced to hold larger amounts of cash. To expand credit effectively, banks must maintain surplus cash reserves.
6. Amount of Cash: The overall cash available in the country imposes another limit on how much credit commercial banks can create. This total cash supply is determined by the government’s monetary policy, and the central bank has the authority to adjust it as needed.
7. Public Confidence: Credit creation relies heavily on the public's trust in a stable and reliable banking system. Banknotes are essentially promises to pay, and people accept and use them for buying goods and settling debts. For banks, deposits are liabilities, and increasing deposits means increasing their obligations. If public confidence is lost, it can lead to panic, causing chaos and instability in the entire banking system.
8. Nature of Process: Another restriction comes from how deposits are actually created. Each loan issued by a bank must be backed by some valuable form of security. Without such security, credit creation becomes ineffective. This shows that banks don’t generate money from nothing, they rely on real assets to support their lending.