Assignment of Money, Banking and Finance

Topic: Do banks Create Credit? Submitted to: Miss Sundas Shahnawaz

Submitted By: Humayun Khalid Qurashi B.com (Hons) 3rd Semester Roll # 04/Regular hkqurashi@gmail.com

Department of Commerce

Do Banks Create Credit?

Do Banks Create Credit?

Contents at Glance
Sr.# 1 2 3 4 5 6 Topics Preface Introduction of Credit Creation Process of Credit Creation Contraction of Credit Limitations of Credit Creation References Page. # 5 6 6 10 11 12

Do Banks Create Credit?

Do Banks Create Credit?

Preface
This assignment includes on the Credit Creation, its Contraction and Limits of Credit Creation. What is Credit Creation and how its created by Commercial banks. Credit Creation Examples will clarify the Process of Credit Creation. **********************************

Do Banks Create Credit?

What is Credit Creation?

Credit Creation does not mean that banks mint notes and coins. By creation of credit it meant that the commercial banks by taking on deposits and making loans expend the money supply and circulation. A question is that Do Banks Actually Create Credit? The answer is Yes. Creation of credit does not mean minting of money. It is the expending of money supply by banks by taking deposits and making loans. Credit Creation is one of the important functions of commercial banks. Credit creation is the multiple expansion of banks demand deposits. It is an open secret that banks advances a major potion of their deposits to the borrowers and keeps a smaller part of them for payments to the consumers on demand. Even the customers of banks have fully confidence that their deposits lying in the banks are quite safe and can be drawn any time on demand. This tendency on the part of commercial banks to make loans several times of the excess of cash reserves kept by the banks is called Credit Creation.

Process of Credit Creation

A single bank cannot create loans. Whole banking system works for credit creation. it is the multiple expansions of banks demand deposits. This cannot happen in the single bank economy and it is applicable only in the two or more banks economy. One bank opens a deposit account in the name of the debtor and allows him to draw when required. Through this process the loan advanced becomes the gain of deposit by some other bank. In this way loans become the deposits and the deposits appear as loans.(Ref 1) Example Let us assume that there are more then one banks in the country. It is further assumed that the required reserve ratio* is 20%. Mr. Ali deposits Rs. 1000 in the MCB. For simplicity sake we will show new changes in the assets and liabilities only. The balance sheet of MCB now appears as under:

MCB
Liabilities Demand Deposits RS. 1000 Assets Cash received Rs. 1000

Do Banks Create Credit?

We assume now that Mr. Burhan approaches MCB for loan. The MCB sets aside 20% or Rs. 200 of new deposit as required reserves and the balance of Rs.800 is loaned out to Mr. Burhan the balance sheet of MCB after giving loan would be as under:

MCB
Liabilities Demand Deposits Total RS. 1000 ---1000 Assets Cash Reserves Loan to Mr. Burhan Total Rs. 200 800 1000

We now assume that the borrower Mr. Burhan makes a payment of Rs. 800 by cheque to Mr. Ahmad to pay off his debt. Mr. Ahmad has an account in Habib Bank Ltd. and he deposits this amount in his account. The Habib Bank receives Rs. 800 as deposit and its balance sheet now appears as under:

Habib Bank Ltd.

Liabilities Demand Deposits RS. 800 Assets Cash received Rs. 800

We further assume that Mr. Furqan approaches Habib Bank Ltd. for loan. The Habib bank keeps 20% of Rs.800 as cash reserves (Rs.160) and the balance amount of Rs. 640 is given as loan to Mr. Furqan the balance sheet of Habib Bank Ltd. will now appears as follow.

Habib Bank Ltd

Liabilities Demand deposits Total RS. 800 ---800 Assets Cash Reserves Loan to Mr. Furqan Total Rs. 160 640 800

Mr. Furqan utilizes the loan of Rs.640 to pay off debt to Mr. Mutee-ur-Rahman who deposit this amount in his bank named as Habib Metropolitan. The balance sheet of Habib Metropolitan increases by Rs.640. the Habib Metropolitan bank also keep 20% as required reserves (Rs.128) and gives excess reserves of Rs.512 as loan to Mr. Zaheer. The amount loaned out to Mr. Zaheer becomes a new deposits at another bank named as Atlas bank. If the process of creating secondary deposits is continued, then at each stage in this sequence, the amount of new loan gets smaller and smaller.
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Do Banks Create Credit?

The initial or primary deposit of Rs. 1000 with bank MCB, leads to the creation of secondary deposits of Rs. 800 in the first round, Rs. 640 in the second round, Rs. 512 in the third round and so on and so forth. The total increase in the deposits from the initial Rs. 1000 increase in reserves is 5000. The increase in five fold, the reciprocal of the reserves requirements which is shown in the table below. In case the require reserve ration is 10% and the initial increase in the reserves is RS. 1000, the credit expansion as a whole is Rs. 10,000. The increase is ten fold the reciprocal of the reserve requirement = Example of credit Creation by banking system (assuming 20% reserves requirements and a Rs. 1000 in deposits) Banks MCB Habib Bank LTd Habib Metopolitan Bank Atlas Bank Bank A.B.C Bank D.E.F Bank G.H.I Bank J.K.L Bank M.N.O Total Payment Deposit (Rs.) 1000 (initial) 800 640 512 410 328 262 210 --4162 Cash reserves at 20% (Rs.) 200 160 128 102 82 66 52 42 --832 Credit Creation (Rs.) 800 640 512 410 328 262 210 168 --3330

The table shows the following points. If the cash reserve ratio is 20% and The initial deposit is Rs. 1000, the bank creates newly money of Rs.3330. the total demand deposits are 4162 (Which are done) (initial deposit Rs. 1000+ credit creation)

Note=> All the Names and Figures taken are completely assumed and fictitious.

Do Banks Create Credit?

Deposit Chain of Credit Creation by different banks:

Rs. 1000 (initial deposit)

Rs. 200 on reserve

Rs.800 lent out

Rs.800 deposit

Rs.160 reserves

Rs. 640 lent out

Rs. 640 deposit

Rs. 128 reserves

Rs. 512 lent out

The Chain will be continue till the deposit amount goes to an end

Do Banks Create Credit?

Contraction of Credit Just as deposit creates loans and loans create deposit, similarly the withdrawal of deposit contracts credit. For example, if the cash reserves ratio is 20% the initial reduction is Rs. 1000 in bank MCB, will lead to a reduction of deposit of Rs.800 in Habib Bank Ltd, and so on. Credit Multiplier: The credit creation by bank is influenced by credit multiplier. It is the reciprocal of the required reserves.

With an initial deposit of Rs. 1000 in bank MCB the change in deposit is= Rs 1000 x 5 = Rs. 5000.

D= Represents the change in the Banking System as a Whole R= Represents the Required Reserves Ratio E= Represents the Primary Deposits

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Do Banks Create Credit?

Limits to Credit Creation:
The capacity of banks to create the credit is subject to certain limitations which are given below.

1) Cash Drain
In the case of chain process of multiplier expansion/contraction of credit, it is assumed that all payments are made by cheques and not in cash form. In case, some borrowers or most of borrowers withdraw a part or the entire amount loaned to them in cash form, banks will not able to create credit to the desire extent. An outflow of cash from the reserves of banks will reduce their ability to expand deposits and vise versa. There will be no reserves for common man.
No Fair Credit for common man

2) Transfer of Deposits to Non bank Financial Institutions

The transfer of funds to non bank Financial Institutions can also limit the credit creation ability of the banks.

3) Willingness to Borrowers
The banks may not be able to take full advantages of credit expansion if they are unable to find sufficient qualified borrowers willing to apply for loan. This is likely to be in case during a recession where banks confidence is low.

4) Different Types of Loans.

It is assumed that all deposits in the banks are in the form of current deposits only. The fact is otherwise. The banks keep a fairly large deposit in the form of saving and time deposits.

Conclusion:
To conclude, we can say that credit creation by banks is one of the important & only sources to generate income. And when the reserve requirement increased by the central bank it would directly affect on the credit creation by bank because then the lendable funds with the bank decreases and vice versa. The multiple deposits creation model seems to indicate that the Central Bank of the country has complete control over the level of current deposits by setting up the required reserves ratio. The fact is that all the four players i.e. the central bank, the commercial banks, depositors and the borrowers are important in the determination of credit expansion. ************************************************

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Do Banks Create Credit?

Data References
Book Reference Money, Banking and Finance by M.Saeed Nasir

Web sites http://en.wikipedia.org/ http://wiki.answers.com/ http://www.blurtit.com/

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