PROCESS OF CREDIT CREATION

 Credit creation is the process by which the money supply of a country or of an economic
or monetary region is increased.
 In most modern economies, most of the money supply is in the form of bank deposits. So
credit creation is also known as ‘Deposit Creation’.
 The banks increase the amount of deposits in their system by lending out money to
borrowers.
 The bulk of "money" in circulation is created through this process.
 Basically, when a bank makes a loan, it simultaneously creates a matching deposit in the
borrower's bank account, thereby creating new money.
 In simple terms, credit creation is the expansion of deposits. Banks can expand their
demand deposits as a multiple of their cash reserves because demand deposits serve as
the principal medium of exchange
 For example, if a customer takes out a loan of Rs. 10,000, the bank does not transfer
existing money, but writes the amount into the customer's account. In this way, Rs.10,000
of new, additional money is created.

Terms:

 Primary Deposits – A bank accepts cash from the customer and opens a deposit in his
name. This is a primary deposit. This does not mean credit creation. These deposits
simply convert currency money into deposit money. However, these deposits form the
basis for the creation of credit.
 Secondary or Derivative Deposits – A bank grants loans and advances and instead of
giving cash to the borrower, opens a deposit account in his name. This is the secondary or
derivative deposit. Every loan crates a deposit. The creation of a derivative deposit means
the creation of credit.
 Cash Reserve Ratio (CRR) – Banks know that all depositors will not withdraw all
deposits at the same time. Therefore, they keep a fraction of the total deposits for meeting
the cash demand of the depositors and lend the remaining excess deposits. CRR is the
 percentage of total deposits which the banks must hold in cash reserves for meeting the
depositors’ demand for cash.
 Excess Reserves – The reserves over and above the cash reserves are the excess reserves.
These reserves are used for loans and credit creation.
 Credit Multiplier – Given a certain amount of cash, a bank can create multiple times
credit. In the process of multiple credit creation, the total amount of derivative deposits
that a bank creates is a multiple of the initial cash reserves

The two most important aspects of credit creation are:

1. Liquidity – The bank must pay cash to its depositors when they exercise their right to
demand cash against their deposits.
2. Profitability – Banks are profit-driven enterprises. Therefore, a bank must grant loans in a
manner which earns higher interest than what it pays on its deposits.

Process:

There are two ways of analysing the credit creation process:

1. Credit creation by a single bank

2. Credit creation by the banking system as a whole

 Money supplied by commercial banks is called credit money.

 Commercial Banks create credit by advancing loans and purchasing securities.
 They are required to keep a certain amount as reserve with the central bank for serving
the cash requirements of the depositors and rest of the amount will be used for lending
purpose.
 The process of credit creation can be understood through the following example:

 Suppose, there exist a number of banks, A, B, C etc., each with different sets of
depositors.
 Every bank has to keep 10% of cash reserves, according to law, and,
 A new deposit of Rs. 10,000 has been made by Mrs. X with bank A to start with.
 Then the bank keeps Rs. 1000 in cash reserve and lends Rs. 9000 to another person
Y.
 They open a credit account in the borrower’s name for the same to which the loan
amount was transferred.
 Assume that he purpose of Y to take loan is that he is a debtor to person D and he had
paid that amount to D. D has deposited the amount to Bank B having cash reserves as
10% i.e. Rs. 90 and lends Rs. 8910 to another person G and this continues till the
loanable amount becomes insignificant.

The credit multiplier depends on CRR. The Credit multiplier can be calculated by the following
formula :

Credit Multiplier (CMC) = 1/r where r is the percentage of CRR

The total credit creation can be calculated using the following formula:

Total credit creation = Original deposit x Credit multiplier coefficient

Thus, from the above example total cash reserve ratio will be : 10,000 x 1/10% = 1,00,000

Therefore the credit creation process will continue till the amount becomes Rs. 1,00,000 in the
above example.
LIMITATIONS:

The power of commercial banks to create credit is not unlimited but there are many limitations
on the power of banks for the creation of credit, as follow:

1. Cash Reserve:

A bank cannot lend all of its funds. It has to keep a reasonable portion of its funds meet
the demand of its customers (depositors). If more funds are required to meet the demand
of depositors, then the power of credit creation will be lower.

2. Central Bank Policy:

The commercial banks are not independent in connection with leading. The central bank
of the country can impose certain restrictions on banks to create credit or to expand loans
by credit control measures.
3. Primary Deposits:
Banks can create credit only if they get primary deposits that is why it is said that
“deposits create credit and credit creates deposits”.
4. Lack of Securities:
Banks cannot expand deposits by granting loans and advances unless proper securities are
available. The total volume of income - yielding securities available in the country sets
the overall limit to the process of credit creation.
5. The Business Environment:
Loans are taken only when sound investment opportunities are available. During
recessions and depressions, deposits tend to go down. The business situation in the
country is an important factor which determines the volume of credit.
6. Lack of Cash:
The total amount of cash, available to the banking system limits the volume of credit that
can be created. Credit is based on cash. The banks must keep a certain percentage of cash
reserve. The total volume of credit cannot ordinarily be larger than the total amount of
cash available multiplied by the customary reserve-ratio. The Central Banks control
credit by measures, like open market operations and variations of the reserve ratio, which
 affect the quantity of cash in the hands of the banks and thereby influence their lending
policy.
7. The Habits of the People:
The habit regarding the holding of cash can affect credit creation. If liquidity-preference
increases, there will be less cash in the hands of the bank and they will be forced to lend
less. In countries with an under-developed banking system, the people tend to hoard cash.
This reduces the power of banks to create credit.
8. Leakages:
In the chain of deposit creation there may occur leakages. Some borrowers may keep a
part of their money in hand without putting it in a bank. The total volume of deposits will
then be lower than the maximum possible. A similar leakage may occur at the bank’s
vaults. A particular bank in the chain may choose to keep a higher reserve ratio and lend
less.