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Credit creation

Credit creation means that on the


basis of primary deposits
commercial banks make loans and
expand the money supply. It results
in multiple expansion of banks
demand deposits.
It is an open secret that banks advance a major
portion of their deposits to the borrowers and
keep smaller part of them for the payment to the
customers on demand.
Even then the customers of the banks have full
confidence that their deposits lying in the banks
are quit safe and can be withdrawn on demand.
The banks exploit this trust of the customers and
expand loans several times than the amount of
demand deposits possessed by them.
This tendency on the part of the commercial
banks to make loans several times of the
excess cash reserves kept by the bank is called
creation of credit.
Do banks really create credit or deposits?

There have been two views on this subject: one held by certain
economists like Hartley Withers, and the other held by practical
bankers like Walter Leaf.

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 the
clearing house. So long as a loan is due, a deposit of that
amount remains outstanding in the books of the bank. Thus
every loan creates a deposit. But this is an exaggerated and
extreme view.

Dr Leaf and practical bankers do not agree with this view. They
go to the opposite extreme. They hold that banks cannot create
money out of thin air. They can lend only what they have in
cash. Therefore, they cannot and do not create money.
This view is also wrong because it is based on arguments relating to
a single bank. As pointed out by Prof Samuelson. The banking
system as a whole can do what each small bank cannot do: it can
expand its loans and investments many times the new reserves of
cash created for it, even though each small bank is lending out only
a fraction of its deposits.

In fact, a bank is not a cloak room where one can keep currency
notes and claim those very notes when one desires. Banks know by
experience that all depositors do not withdraw their money
simultaneously. Some withdraw while others deposit on the same
day. So by keeping small cash in reserve for day-to-day
transactions, the bank is able to advance loans on the basis of
excess reserves. When the bank advances a loan it opens an
account in the name of the customer.

The bank knows by experience that the customer will withdraw


money by cheques which will be deposited by his creditors in this
bank or some other bank, where they have their accounts.
Settlements of all such cheques are made in the clearing house.
The same procedure is followed in other banks. The banks are able
to create credit or deposits by keeping small cash in reserves and
lending the remaining amount.
Process of Credit creation
The existence of a number of banks, A, B, C
etc., each with different sets of depositors.
Every bank has to keep 20% of cash reserves,
according to law, and,
Suppose, a person deposits Rs. 1,00 cash in
Bank A. As a result, the deposits of bank A
increase by Rs. 1,00 and cash also increases by
Rs. 1,00.
Balance sheet of bank A
Liabilities Assets

Demand Deposits 100 Cash 100

Total 100 Total 100


Under the double entry system, the amount of
Rs. 1,00 is shown on both sides. The deposit of
Rs. 1,00 is a liability for the bank and it is also an
asset to the bank. Bank A has to keep only 20%
cash reserve, i.e., Rs. 20 against its new deposit
and it has a surplus of Rs. 80 which it can
profitably employ in the assets like loans.
Suppose bank A gives a loan to X, who uses the
amount to pay off his creditors. After the loan has
been made and the amount so withdrawn by B to
pay off his creditors, the balance sheet of bank A
will be as follows:
Balance sheet of bank A
Liabilities Assets

Demand Deposits 100 Cash 20


Loan to B 80

Total 100 Total 100


Suppose B purchase goods of the value of Rs.
80 from C and pay cash. C deposits the
amount with Bank B. The deposits of Bank AA
now increase by Rs. 80 and its cash also
increases by Rs. 80. After keeping a cash
reserve of Rs.16, Bank AA is free to lend the
balance of Rs. 64 to any one. Suppose bank AA
lends Rs. 64 to d, who uses the amount to pay
off his creditors.
Balance sheet of bank B
Liabilities Assets
Demand Deposits 80 Cash 16
Loan to D 64
Total 80 Total 80
Suppose D purchases goods of the value of Rs.
64 from S and pays the amount. S deposits
the amount of Rs. 64 in bank C. Bank C now
keeps 20% as reserve (Rs.12.80) and lends Rs.
51.20 to a merchant. And this goes on till nth
round then
The table shows the following points
(i) If the cash reserve ratio is 20%and
(ii) the initial deposit is Rs 100
The banks creates newly created money of Rs
400.
The total demand deposits are Rs 500 (initial
deposit Rs 100 + credit creation Rs 400 = Rs
500).
The credit multiplier is the reciprocal of the
required reserve ratio.
Credit multiplier = 1/required reserve ratio
If reserve ratio is 20%
Then credit multiplier = 1/0.20 = 5
Limitation on Credit Creation
The commercial banks do not have unlimited power of
credit creation. Their power tocreate credit is limited
by the following factors:
1. Amount of Cash
2. Cash Reserve Ratio
3. Banking Habits of the People
4. Nature of Business Conditions in the Economy
5. Leakages in Credit-Creation
6. Sound Securities
7. Liquidity Preference
8. Monetary Policy of the Central Bank
Limits to credit creation
The capacity of the bank to create credit is
subject to certain limitations which are given
below.
(i). Cash Drain
(ii). Transfer of deposit to non bank financial
institution
(iii). Willingness to borrow
(iv). Different types of loan
What are the limitations of credit creation?

Commercial Banks though have the power to create credit,


their powers are not unlimited. Certain points affect the
process of credit creation. They are termed as limitations to
credit creation by commercial banks.

Limitations of Credit Creation by Commercial Banks


1. Amount of Deposit

The most important factor which decides credit creation is


the amount of deposits made by the depositors. Higher is the
amount of deposits, greater is the supply of credit and vice
versa.

2. Cash Reserve Ratio (CRR)

There exists an indirect relationship between Credit Creation


and Cash Reserve Ratio (CRR). Higher is the Cash Reserve
Ratio (CRR) more will be the reserves to be maintained and
less credit will be created by banks. The CRR is fixed by the
RBI in India. It ranges between 3% to 15%.

3. Banking Habits of People

If the banking habits of the people are well-developed, then


all their transactions would be through banks, and this will
lead to expansion of credit and vice-versa.

4. Supply of Securities

Loans are sanctioned on the basis of the securities provided


to the banks.
to the banks. If securities are available then the credit
creation will be more and vice-versa.

5. Willingness of people to borrow

Commercial banks may have enough money to lend.


Customers should be willing to borrow from the banks to
facilitate credit creation. If they are willing to borrow, then the
credit created by banks will be less.

6. Monetary Policy of Central Bank

While credit is created by commercial banks, it is controlled


by the Central Bank. Credit control is one important function
of the central bank. Central Bank uses various methods of
Credit Control from time to time and thus influences the
banks to expand or contract credit.

7. External Drain

External Drain refers to withdrawal of cash from the banking


system by the public. It lowers the reserves of the banks and
limits the credit creation.

8. Uniform Policy

If all the commercial banks follow a uniform policy related to


CRR, then credit creation would be smooth. If some banks
follow liberal and others follow a conservative one, then credit
creation would be affected.
Mechanism of Credit Creation by Bank
While dealing with the historical aspects of banking, we have
seen how the early gold smiths of England hit upon the idea of
making profit by lending, on interest, a safe amount out of the
money deposited with them by their owners for safe custody.
They had observed, from experience, that only a certain
fraction of the total amount of deposits needed to be kept with
them in reserve to see that they did not fail any depositor when
the latter claimed his money back.
So the rest of the money (gold, silver and other valuables)
could be used profitably by others, which would bring in
sizeable interest income to the gold smith bankers.
But what margin of the total deposit ought to be kept in reserve
as ready cash, and what precautions had to be taken by the
bankers to see that the loan-taker would not fail, etc., were left
in those days to the bankers own discretion.
This often led to tragedies. Gradually the institution of a Central
Bank came into existence, and the banks were made to strictly
maintain a strict ratio between the total deposits they create
(mostly credit deposits) and the cash in their possession.
We shall be dealing with this minimum cash reserves in greater
detail when we deal with the institution of Central Bank. For the
purpose of our present study, we assume that all banks in our
economy are obliged to keep the ratio between cash and its
deposits data minimum of 20% (1/5).
We will also assume that (i) the banks do not keep any
excess reserves. In other words, it would exhaust all
possible avenues of income earning activities like giving
loans etc. up to the maximum extent after attaining the
minimum cash reserve; (ii) there are no drains in the
supply of money, i.e. the public do not suddenly want to
hold more idle currency or withdraw from the time deposits.
Under the above assumptions, let us see what happens
when a customer deposits a sum of Rs. 1000 in a bank.
The bank creates a deposit of Rs. 1000 in his favour. A
bank deposit (bank money) has increased by Rs. 1,000.
But, at this stage, there is no increase in the total supply of
money with the public, because the above extra bank
money of Rs. 1,000 is offset by the cash of Rs. 1,000
deposited in the bank.
The bank has now additional cash of Rs. 1,000 in its
custody. Since it is required to keep only a cash reserve of
20%, this means that Rs. 800 is excess cash reserve with
it. According to our assumption, the bank should lend out
this Rs. 800 to the public. Suppose, it does so, and the
debtor deposits the money in his own account with another
bank B, bank is creating a deposit of Rs. 800.
Bank then has also excess cash reserve or Rs. 640. It
could, in its turn, lend out Rs. 640 (80% of Rs. 800). This
Rs. 640 will, in its turn, find its way with, say, bank C; it will
create a deposit of Rs. 640, and so on.
The total deposits will now grow into Rs. 1,000 + Rs. 800 +
Rs. 640 +. till ultimately the excess cash reserve reaches
out. It can be shown that when that stage is reached the
total of the above will be Rs. 5,000.
We will notice that the above was made possible because of the fact
that a bank does not keep in its coffers cash equal to its deposit
liability, but only a fraction of it; in the above illustration.
It can be shown algebraically that if M represents total supply of
money, AM represents increasing supply due to increase in bank
deposits.
R represents the minimum cash reserve ratio expressed as a
fraction.
C represents the additional cash reserves initially injected into the
system (Rs. 1,000 in the above illustration).
M =AC/r
(In the above illustration r = 1/5 and AC = 1,000).
M = 100/1/5 = 5000
This is the mechanism of Multiple Credit Creation. The cash of Rs. 1,
000 has now been converted into bank deposits of Rs. 5,000 of
which Rs. 4,000 is credit money.
It should be care observed that the above mechanism works when
there are several banks in the system, all of which follow the
practices noted in our assumptions. However, there would not be
much difference in the credit creation mechanism even if there were
to be only a single bank.
In this type of situation, the secondary deposit of Rs. 800 would
have come back to the same bank. The bank would keep the
necessary reserve and extend as loan the balance of the deposits.
In this round again, the secondary deposit would come back to the
bank; the process of credit creation would move as if it were a
multi-bank economy.
This study note looks at the balance sheet of commercial banks and how they are able to create
money through the process of credit creation.
Assets and Liabilities of a Commercial Bank

This is a basic model of the balance sheet of a commercial bank

Assets are owned by the bank

Liabilities are owed by the bank e.g. customers can walk into a bank or use an ATM machine to
withdrawal some/all of their deposits

Assets

Cash
Balances at Bank of England
Loans (Advances)
Securities (e.g. Bonds)
Fixed assets
Liabilities

Customer deposits
Money owed to bond holders
Money owed to other banks
Structure of a commercial banks balance sheet

Key point: Bank deposits are simply a record of how much the bank itself owes its customers. So
they are a liability of the bank, not an asset that could be lent out.

Key point: Reserves can only be lent between banks not lent to customers.

Assets and liabilities before and after bank lending


The Old Textbook View of Banks and Credit Creation

Banks take deposits of money from savers and lend it to borrowers


Banks then lend money to businesses, thus allocating funds between alternative investment
projects
How Modern Commercial Banks Create Credit

Banks create credit by extending loans to businesses and households pure and simple!
They do not need to attract deposits from savers to do this
When a bank makes a loan, for example to someone taking out a mortgage to buy a house, or a
business taking out a loan to finance their expansion it credits their bank account with a bank
deposit of the size of the loan/mortgage.
At that moment, new money is created!

Banks making loans and consumers repaying them are the most significant ways in which bank
deposits are created and destroyed in the modern economy.

(Source: Bank of England)

Alternative (Stylised) View of a Banks Balance Sheet

Retail funding for banks

Retail funding remains the main funding source for UK retail commercial banks
Banks will typically pay a higher interest on retail deposits that are saved with a bank for a longer
period of time. This give them a more secure source of funds.
The saver gets higher interest for sacrificing some liquidity.
The benefit to a bank attracting fresh deposits