Credit Creation
Credit Creation
The creation of credit is one of the important functions of commercial banks. In the
ordinary course of business banks accept deposits from the public and lend money to
its customers. When a bank advances a loan it does not pay the amount in cash. But it
opens an account in the name of the customer and allows him to withdraw the required
amount by cheque. In this way a bank creates credit or deposit which are regarded as
money which can be used for the purchase of goods and services and also for the
payment of debt just like currency notes.
If the banker has more primary deposits, he can lend more and create more deposits.
The initiative for creating the derivative deposits comes from the banking system.
There are two views as to the ability of banks to create credit. According to Withers,
banks can create credit by opening a deposit every time they advance a loan. This is
because every time a loan is sanctioned payment is made through cheques by the
customers. All such payments are adjusted through clearing. So long as the loan is due,
deposit of that amount remains outstanding in the books of the bank. Thus, every loan
creates a deposit.
Edwin Cannan, Waiter and Leaf do not agree with the view. They say that banks cannot
create money out of thin air. They can lend only what they have in cash. So they cannot
and do not create money. The above view is based on the argument relating to a single
bank. So it cannot be considered correct. Prof. Samuelson says that "'The banking
system as a whole can do what each small bank cannot do; it can expand its loans and
investments many times the reserves of cash created for it, even though each small
bank is lending out only a fraction of its deposits."
By experience banks know that all depositors do not withdraw their money
simultaneously. Some withdraw while some others deposit on the same day. So by
keeping a small cash reserve for day-to-day transactions the bank is able to grant loans
on the basis of excess reserves. The amount lent may come back again to the same
bank or some other bank as deposit. The banks whose deposits have increased will
lend. This process will continue till the total deposits have increased by a number of
times the original deposit of cash.
Loans and Advances: Banks provide credit facilities to businessmen by way of loans
and advances, overdraft and cash credit. When a loan is granted or overdraft is
sanctioned, the amount of loan or overdraft is entered in the account of the customer
and he is allowed to draw cheques upto the amount agreed upon. Thus the bank
creates a deposit in the name of the borrower. Banks can create more credit by making
more loans and advances.
Money at Call and Short Notice: Money at call and short notice is given to speculators
and stock brokers for extremely short period ranging from 24 hours to 2 or 3 days. The
bank credits the accounts of the stock brokers or speculators when such facilities are
granted and allows them to draw the amount. They, in turn, issue cheques to their
clients in settlement of their accounts. The persons who receive the cheque may
deposit the same into their accounts. In this way, the money at call and short notice
granted ultimately results in creation of deposits.
Next day one Mr. Y deposits Rs. 5000 with the bank. The BIS of the bank after the new
deposit of Rs. 5000 is made would be as follows:
INDIAN BANK
Balance Sheet
Liabilities Assets
Deposits 8,000 Cash 8,000
8,000 8,000
Indian Bank ha. an excess. of Rs. 6,400 after keeping 20% cash reserve, which it can
lend or invest. Let us further assume that the bank buys securities worth Rs. 6.400 from
Mr. J. After this transaction, the Balance Sheet of the bank would be:
INDIAN BANK
Balance Sheet
Liabilities Assets
Deposits " 8,000 Cash 1,600
Investment 6,400
8,000 8,000
The bank may give a cheque for Rs. 6,400 to Mr. J which may be deposited in his bank
or the account of Mr. J will be credited with Rs. 6,400 which he may draw at any time. In
the above illustration, the initial cash of Rs. 10,000 has created a loan of Rs. 8,000,
which has become a deposit in another bank. The new deposit has generated another
deposit of Rs. 6,400 and this process would continue till the original deposit is
exhausted completely.
The higher the cash reserve ratio the lower will be the deposit multiplier. The total
creation is additional cash multiplied by deposit multiplier, K.
Supposing, the commercial banks get an additional cash, Rs. 100 crores as a result of
Government spending, they would be able to create to the extent of Rs. 500 crores
assuming a cash reserve of 20 per cent. That is,
Credit creation = K x 100 crores
= 5 x 100 = 500 crores
Credit Contraction
Commercial banks are able to multiply credit when deposits are made with them. If cash
is removed from the banking system, it results in multiple contraction of credit.
(1) There is one bank having a cash reserve of Rs. 1,000, investment Rs. 9,000 and
deposits Rs. 10,000.
(2) The bank is required to keep 20% cash against the deposit.
Supposing Rs. 100 cash is withdrawn from the bank, the Balance Sheet of the bank
would appear as-follows:
Balance Sheet
Liabilities Assets
Deposits 9,900 Cash 900
Investment 9,000
9,900 9,900
Against a deposit of Rs. 9,900, the bank has got cash reserve of Rs.900 only. But it
should have cash reserve of Rs.1,980. To make good the deficiency, Rs.1,080, the
bank may either realise the loan or dispose of its investments. Getting back the loan at
once is difficult. So the bank will make up the deficit by disposing the investment worth
of Rs.1,080.
Assume that the bank sells the security to a who issues a cheque against his bank for
payment. After the amount is collected the Balance Sheet of the bank would be as
follows:
Balance Sheet
Liabilities Assets
Deposits 9,900 Cash 1,980
Investment 7,920
9,900 9,900
Similarly, other banks may have to dispose of their securities as a result of reduction in
the cash reserve. This process will go on till all the effects are exhausted. The initial
reduction of Rs. 100 will lead to a total decline of deposits to the extent of Rs. 500.