BANKING

Question # :a)- How does a Commercial Bank Create Credit?

b) - Indicate the limitations on the powers of a bank to Create Credit.
OR
Deposits Create Loans and Leans Create Deposits, discuss.
OR
Loans are children of deposits or Deposits are children of
Loans, discuss.

INTRODUCTION

The word Credit has been taken from a Latin word “Credo”. The word “Credo” means “I Trust
You”.
Credit means confidence of lender in borrower’s ability to repay. In simple words credit means a loan.
So creation of credit is one of the most important functions of a modern bank. A bank sometimes has
been called a factory for the manufacturing of credit.

DEFINITIONS

According to BENHAM:
“A bank may receives interest simply by permitting a customer to overdraw
his account or by purchasing securities and paying for them with its own
cheques. Thus, increase in the total bank deposits, one should remember
that single bank creates a very little credit. It is a whole banking system
which can expand the credit”.

According to PROF. FLY:

“To higher the amount of deposits, the more will be the capacity of banks to
create credit. They invite more deposits by alluring higher rate of interest”.

TYPES OF DEPOSITS
There are two main types of deposits;
1. Direct or Primary Deposits:
These deposits consist of the money deposited with the bank by its customers.
2. Indirect or Secondary Deposits:
These are the deposits which are created by a bank in the process of its lending or financing
activities.

PROCESS OF CREDIT CREATIION

Suppose all the banks of a country cooperate with each other for the purpose of credit
creation. Further suppose that;
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 Cash Reserve Ratio is 20% of the total Cash Deposits.

 Bank Lend whole Amount in Excess of Cash Reserve.
 Central bank allows bank to give credit as bank want.
 All payments and receipts are made by cheque.
Let us suppose a new bank “X” is organized and a person deposits in it Rs.10,000. Balance
Sheet of “X” is as follow;
BANK “X”
BALANCE SHEET

Assets Rs. Liabilities Rs.

Cash 10,000 Direct Deposits 10,000
Total 10,000 Total 10,000

As cash reserve ratio is 20%. So bank has Rs. 2,000. as reserve and Rs.8, 000. for lending up.
Now suppose, that bank advances Rs.8, 000 to a customer “Mr. A” Bank will not give this amount in the
form of cash but credit this amount to his account. Thus the bank has created deposits with
Rs.8, 000. After creation of this transaction the balance sheet of bank ”X” will look as;
BANK “X”
BALANCE SHEET
Assets Rs. Liabilities Rs.
Cash 10,000 Direct Deposits 10,000
Loan to “A” 8,000 Indirect Deposits 8,000
Total 18,000 Total 18,000

If there is only one bank then only a deposit of Rs.8, 000 can be created.
Now suppose that customer “A” withdrew his amount by cheque and pay it to his creditor ‘B’ who has
also account in Bank “Y” and deposited the same amount in bank “Y”. the balance sheet of Bank Y
after giving loan;
BANK “Y”
BALANCE SHEET
Assets Rs. Liabilities Rs.
Cash 8,000 Direct Deposits 8,000
Loan to ‘C’ 6,400 Indirect Deposits 6,400
Total 14,400 Total 14,400

Now suppose Mr. ‘C’ borrows Rs.6, 400 from bank ’Y’ and purchases goods from Mr. ‘D’ who has
account in bank ‘Z’. Mr. ‘D’ deposited the amount in Bank ‘Z’. The balance Sheet of Bank ‘Z’ after
giving loan;

BANK “Z”
BALANCE SHEET
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Assets Rs. Liabilities Rs.

Cash 6,400 Direct Deposits 6,400
Loan to ‘E’ 5,120 Indirect Deposits 5,120
Total 11,520 Total 11,520

The credit Creation process can be summed up and can be illustrated in the following table:

SUMMARY FORM
Bank Deposits Rs. Cash Reserves Loans @ 80%

X 10, 000. 2, 000 8, 000

Y 8, 000 1, 600 6, 400
Z 6, 400 1, 280 5, 120
OTHER 5, 120 === ===
OTHERS === === ===
==== === === ===

TOTAL 50, 000 10, 000 40, 000

Formula:
A very simple formula for working out total credit creation is as follows;

Credit creation = [original Deposits] x 1 .

Cash Reserve Ratio

= 10, 000 x 1 / 20%

= 10, 000 x 100 / 20 = Rs. 50, 000.

LIMITATIONS

Banks have not unlimited credit creation powers. The following are the limitations on the
power of commercial banks to create credit:

1. Cash Reserve:
The commercial banks have to keep a large portion as cash reserve to honor cheque of the
customer. The amount of cash reserve cannot be used for credit creation.

2. Central Bank Action:

The commercial bank has to keep some percentage of their deposits with the central bank. It
reduces the credit creation capacity of the commercial banks.

3. Political Stability:
If political conditions of country are not stable then no body takes risk to invest in new business. So
banks cannot create much credit.
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4. Habits of Customers:
The power to create credit by commercial banks is very much influenced by the habit of the people
living in that country. If people are habitual in using the cash instead of cheque then bank cannot
create much credit.

5. Proper Security:
The banks advance loans against some proper securities. If the securities are not available then
the bank cannot create much credit.
6. Primary Deposits:
The primary deposits are the basis of banking business. The credit creation is not possible if the
people like to keep cash with them.

7. Business Conditions:
People take loan from banks only if there are good business conditions in the country but if political
and economic situation in the country is uncertain, then people hesitate to take loan. So banks
cannot create much credit.

8. Currency Conditions:
If the currency is in depreciating condition due to an over issue of paper money, the credit will
contract. Thus currency conditions also influence on credit creation.

9. Different Types of Deposits:

It is assumed that all the deposits in the banks are in the form of demand deposits only. The fact is
otherwise, the bank keeps a fairly large deposit in the form of savings or time deposits.

10. Willingness to Borrow:

A commercial bank can create credit only if customers are willing to borrow but if they are not willing
to borrow then the credit creation is also not possible.

11. Behavior of Other Banks:

The power of credit creation is further limited by the behavior of other banks. If some of the banks
do not advance loans, the chain of credit expansion will be broken.

12. Knowledge of Banking:

If people are illiterate, the credit creation is decreased. If people are educated and they have
complete knowledge about banking then credit creation may be increased by banks.