आर्थिक तथा बैकिङ्ग ज्ञान : जिज्ञाशा न. १३ : How does the banking system create credit in an economy?

Credit creation is a procedure whereby the banks and financial institutions create loans and advances from the public deposits and other sources available to them. The amount of money deposited for the first time in the bank account is called primary deposit. The bank lends to others from that amount which can come back to other banks in the form of secondary deposits. Creation of such secondary deposits can continue for a long time with the creation of newer and newer loans from such secondary deposits. With this process, the banking system can create a large amount of credit with the fixed amount of money deposited in the banks initially.

We can explain the process of credit creation in two different scenarios below: 

 (i) Under Single Bank System:

To explain how the banking system with a single commercial bank creates credit, suppose that there is a single bank‘Bank X’ and the cash reserve ratio fixed by the central bank is 20 percent and also assume that the bank does not keep any other cash balance with itself.

Now, when a customer say ‘Customer A’ comes to the bank to make a deposit of Rs. 100 at his/her account, it is called primary deposit. Out of that deposit, the bank maintains a reserve of Rs. 20 at the central bank to fulfill the CRR  requirement and can lend the remaining Rs. 80 to some customer say ‘Customer B’. The bank deposits Rs. 80 in B’s account which increases the deposit of the banking system by Rs. 80. It is called derivative deposit because such a deposit comes out of the original deposit of Rs. 100. Even if B withdraws that money, that will ultimately return to the same bank as there are no other banks in the system. The bank now has to maintain 20 percent of the new deposit Rs. 80 (i.e. Rs. 16) as cash reserve ratio and can lend the remaining to another customer. This process continues until the primary deposit of Rs. 100 is all used up in maintaining the cash reserve ratio.

The whole process of credit creation can be explained below.

Step	Deposit (D)	Required Reserves (r.D)	Credit Creation (C)	Deposit	Required Reserves	Credit Creation
I	100	0.2*100=20	0.8*100=80	D	r.D	(1-r)D
II	80	0.2*80=16	0.8*80=64	(1-r)D	r(1-r)D	(1-r)2 D
III	64	0.2*64=12.8	0.8*64=51.2	(1-r)2 D	r(1-r)2 D	(1-r)3 D
..	…	…	…	…	…	….
..	…	…	…	…	…	….
..	…	…	…	…	…	….
Total       500		100	400	D/r	D	(1-r)/r)D

The total credit creation is: (1-r)D+(1-r)² D+(1-r)³ D+(1-r)⁴ D+…….and so on

=D{(1-r)+ (1-r)² +(1-r)³+(1-r)³+……….}

Here, the series inside the bracket is a declining geometric series with infinite terms, its summation can be calculated as: S = a/1-r, Where a=first term and r = common ratio

= {1-r/(1-(1-r)} D

= {1-r/r} D

Credit Creation = {1-r/r} D

Credit Creation=Credit Multiplier (1-r/r) × Primary Deposit (D)

Thus, the total credit creation power depends on the cash reserve ratio. If the CRR ratio is reduced to 10 percent, total credit creation would be 100/0.1= Rs. 1000

The above system works perfectly only when the following conditions are fulfilled:

1. People do not keep cash balances with themselves.

2. The bank need not keep any extra cash balances with them.

But in most cases, the above two assumptions do not hold as such the credit creation capacity of the banking system will be smaller than that given by the above mechanism.

(ii) Multi Banking System

The process of credit creation under multiple bank system differs from that of single bank system basically in one respect - the derivative deposits may no longer return to the bank where primary deposit was made. It is because the public may choose other banks to keep the money which is withdrawn from the loan account of a bank. Whatever the case, the total volume of credit generated remains unaffected. For example the first bank provides a loan of Rs. 80 to customer A, out of the deposit Rs. 100 (CRR is 20 percent).  Now, wherever the customer deposits that money (in the same bank or the other, that amount can create a loan of Rs. 64 only because the rest Rs. 16 should be kept in the form of required reserves. Thus, it does not matter for the banking system as whole where the deposits are made. The total credit creation is again the same as in the above case.

This can be explained with the following example:

Bank	Customer Making Deposit	Deposit (D)	Required Reserves (r.D)	Credit Creation (C)	Customer taking Credit
I	Customer A	100	0.2*100= 20	0.8*100=80	Customer B
II	Customer B	80	0.2*80= 16	0.8*80=  64	Customer C
III	Customer C	64	0.2*64= 12.8	0.8*64=51.2	Customer D
..	…	…	…	…	…
..	…	…	…	…	…
..	…	…	…	…	…
Total		500	100	400

Factors Affecting Credit Creation

a) Amount of Deposit

Higher the cash collection of the commercial banks in the form of public deposits, the more will be the credit creation. Deposit collection depends on a lot of factors like the remittance inflow in the country, interest rate offered by the banks, rate of inflation, central bank policies regarding money supply, rate of capital and investment inflow in the country, etc.

(b) CRR

The cash reserve ratio has a negative impact on the credit creation capacity of the banking system. When CRR is raised, the amount available for lending from the banks is automatically reduced as such the whole credit creation process shrinks down.

(b) Excess Reserves

Besides the cash reserve ratio, banks maintain extra cash reserve to fulfill the transactions needs of depositors and to ensure the safety and liquidity of commercial banks. In this ratio rises, the credit creation capacity of the banking system is reduced and vice versa.

(d) Leakages

The amount withdrawn from the bank may not completely return to the banking system as public may some keep cash with themselves. It reduces the credit creation capacity of the banks.

(e) Availability of Borrowers, Securities and Proper Economic Climate

For the credit creation process to work perfectly, the banking system should be willing to lend all of their available resources, the individuals should be willing to take loans and there must be proper economic climate to take credit. For instance, if the economy is in recession, the individuals will not take loans as such the credit creation principle does not realize fully.