Question

Point out any three limitations to the credit creation by commercial banks.

What are the limitations to commercial banks' power to create credit?

Write a short note on:

Give any limitations of credit creation.

Point out any two limitations to credit creation by commercial banks.

Answer 1

The ability of commercial banks to create credit is restricted by several factors, with the most significant being as follows:

1. Total Amount of Cash Reserves: The overall volume of cash reserves within an economy determines how much credit commercial banks can generate. When more cash is available in the economy, banks can create more credit, and the reverse is also true. The amount of cash held by the public influences the size of primary deposits in banks, and since credit creation depends on these deposits, it is ultimately limited by them.
2. Cash Reserve Ratio: The ability of banks to create credit is also influenced by the ratio of their cash reserves to total deposits. Banks must maintain two kinds of reserves. First is the statutory reserve, which is a mandatory percentage of deposits that must be kept as cash with the central bank. Second, banks also hold optional reserves to meet withdrawal demands from their customers. Both types of reserves affect the amount of credit banks can extend.
3. Banking Habits of the People: The extent to which people use banking instruments like cheques, demand drafts, and bills in their transactions also impacts the credit creation power of banks. If non-cash methods of payment are common, banks can maintain lower cash reserves, thereby enabling greater credit creation. This is why developed economies, where such practices are widespread, witness higher levels of credit creation.
4. Nature of the Securities Offered: The availability and quality of securities also limit how much credit banks can extend. Banks typically issue loans against collateral, ensuring they have recourse if the borrower defaults. Acceptable securities include shares, bonds, real estate, insurance policies, warehouse receipts, and bills of exchange.
5. Business Conditions: Credit creation by banks is influenced by the overall economic climate. In times of economic growth and optimism, businesses are more willing to borrow and invest, thereby encouraging banks to issue more credit. Conversely, during downturns or recessions, the demand for loans falls, restricting credit expansion.
6. Monetary Policy of the Central Bank: The central bank plays a crucial role in regulating the credit-creating power of commercial banks through its monetary policy. It uses various tools, such as adjusting the bank rate, conducting open market operations, and modifying the statutory reserve requirements to influence the level of cash reserves available to commercial banks, thereby expanding or contracting credit in the economy.