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Credit Creation

Credit Creation: One of the important functions of banking system is the creation of credit. Credit creation is the multiple expansions of banks deposits. Banks advance a major portion of their deposits to the borrowers and keep smaller parts of deposits to the customers on demand. A single bank cannot create credit. It is the banking system as a whole which can expand loans by many times of its excess cash reserves. Further, when a loan is advanced to an individuals or a business concern, it is not given in cash. The bank opens a deposit account in the name of the borrower and allows him to draw upon the bank as and when required. The loan advanced becomes the gain of deposit by some other bank. Loans thus make deposits and deposits make loans.

Deposit Multiplier : A function that describes the amount of money created in a bank's money supply. This money is created by lending money that is in excess of its required reserve to borrowers. Deposit Multiplier =1/ Reserve Ratio

Example: (At Reserve ratio 50%)


Bank
Bank 1 Bank 2 Bank 3 Bank 4 Bank n Total

Liabilities/ Deposits
100 50 25 12.5 00 200

Assets
50 25 12.5 6.25 00 100

Reserve
50 25 12.5 6.25 00 100

Total Assets
100 50 25 12.5 00 200

Limitations of Credit creation: The limitations of credit creation by commercial banks are as follows :1. Amount of Deposit 2. Monetary policy 3. Banking Habits of People 4. Availability of eligible lending options 5. Willingness of people to borrow 6. Credit control policy 7. Asset liability position 8. Liquidity position & ALM 9. Maturity level in the economy

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