Credit Creation (By Commercial Banks)

What is Credit Creation?

Credit Creation refers to the activity of
Commercial Banks to sanction loans.
Loans (advances) sanctioned by banks
are several times greater than the total
Deposits held by the Commercial Bank.

What is a Reserve Ratio?

It is fixed by the Central Bank of the
Country. In the case of India, it is the
Reserve Bank of India. A certain portion of
the total deposits with the bank, is kept in
cash form what is the meaning of Reserve
Fund?
The total cash maintained by a Commercial
Bank.

Example:Suppose the reserve ratio is 10 percent.

Total deposits of a bank are Rs 100
Crores. In such a situation, the bank will
maintain a Reserve Fund of Rs 10
Crores.
The balance of Rs 90 Crores can be
given in the form of loans.

The Procedure:The borrowers are credited with

chequable deposits. The borrowers will
utilise the loans sanctioned to them by the
banks, by issuing cheques drawn on the
bank.
Thus, the excess reserves are available
with it for further lending.

Time

Excess
Reserves

Net Credit

Increase in
Minimum Reserves

1st Round

+100

+100

2nd Round

+90

+90

10

3rd Round

+81

+81

4th Round

+72.90

+72.90

8.10

5th Round

+65.61

+65.61

7.29

1000.00

100.00

The above table, explains the complete

lending system of Commercial Banks.
Cash deposit of Rs 100 Crores results to
Rs 1000. Deposits expanded by ten times
of the original cash deposits.
Thus, the cash deposits in the banking
system lead to multiple expansion of bank
money also known as deposit multiplier or
Credit Multiplier.
The entire process is known as credit
creation. Bank is called a factory for
manufacture of credit.

Formula For The

Deposit Multiplier

Calculation

of

The magnitude of deposit multiplier depends

on the cash reserve ratio.
Deposit Multiplier = K = 1/r
r stands for cash reserve ratio. If the cash
reserve ratio is 10 percent, i.e. = 1/10,
Then, me get
Deposit Multiplier K = 1/0.1 = 10
in this case, initial deposit of certain cash amount
in the banking system will lead to ten times
expansion in total deposit.

Multiple Bank Credit Creation

Alternative approach:- Assumption
1)There are a number of banks such as X,Y
and Z etc. with different deposits.
2)Every bank has to keep 20 percent cash
reserves against its deposits.
3)A new deposit of Rs 1000 is made with bank
X, to start with.
After, a fresh deposit of Rs. 1000 in the bank
X, its balance sheet will be as follows:-

Bank X
Liabilities Asset
New deposit Rs. 1000 New Cash Rs. 1000
Total, 1000 Total, 1000

now, the bank, X , will keep 20 percent

reserve in cash against its Rs. 1000 and the
balance of Rs. 800 will be lent out to some
one, say, Mr. A. after, the loan has been
sanctioned, the balance sheet of bank X
would be as follows:-

Bank Y
Liabilities Asset
Deposit Rs. 1000Cash Rs. 200
Loan to Mr. A, Rs. 800
Total, 1000 Total, 1000

Now Mr. A, Pays off, the amount of Rs. 800 to

his creditor who may be assumed to deposit the
same with his bank, say, Y. The Balance sheet of
the bank Y will be as follows:-

Bank Y
Liabilities

Asset

New deposit Rs. 800

Total, 800

New Cash Rs. 800

Total, 800

Bank will find more cash with itself. It will keep

20 percent ( i.e. Rs. 160 ) of the new cash
received and the balance, i.e.
Rs. 800 Rs. 160 = Rs. 640, will be lent to Mr. B.

This will change the balance sheet of the Bank

Y as follow:-

Bank Y
Liabilities

Asset

New deposit Rs. 800

Total, 800

New Cash Rs. 800

Total, 800

Bank Z
Liabilities

Asset

New deposit Rs. 640

Total, 640

New Cash Rs. 640

Total, 640

Bank Z finds that it cash reserve has

increased. It will keep 20 percent of Rs. 640
( i.e. 128 ) and the balance of Rs. 512 will be
lent out to Mr. C.
After the loan has been sanctioned, the
balance sheet of Bank Z, will be as
follows:-

Bank Z
Liabilities

Asset

Deposit Rs. 640

Cash Rs. 128

Loan to Mr. C, Rs. 512
Total, 640

Total, 640

Likewise Mr. C, will pay off his lenders

(creditor), who would deposit the cheque
money in another bank.
Thus, the process of Deposit becoming loan
goes on and on till the original deposit of Rs.
1000 is completely exhausted.
The original deposit of Rs. 1000 becomes
additional deposit of Rs. 800, 640, 512, 410,
328 etc.
The total amount of deposit expansion would
be reverse of the cash reserve ratio.

Suppose, cash reserve ratio is 20 percent or

1/5, credit exemption would be 5/1. or five
times of the original deposit.
Bank credit i.e. money created by banks
becomes part of the total amount of money
in circulation
It is necessary for the monetary authority to
control the volume of total bank credit in the
Country.

Limits to Credit Creation

1. Ratio of cash reserves to deposits: banks ability to create credit is inversely
related to the ratio of cash reserves to total
deposits
Total Deposits in the Country
Other things remaining the same higher the
total deposits with the banks, greater shall
be the amount of credit creation

Conditions of creation of
credit

Business Conditions in the Country:-

If the business community is optimistic

they will demand more loans and vice
versa
Use of Cheque system: If payments are being made more and
more through cheques, credit creation
will be more & vice versa