Credit Creation by Commercial Banks: Process, Limitations, and Importance
Credit Creation by Commercial Banks
Importance and Functions
Credit creation is a crucial function of commercial banks, constituting a major component of the money supply in an economy. Unlike other financial institutions that merely transfer funds, commercial banks create credit or”bank money” As Professor Sayers aptly stated,”Banks are not merely purveyors of money, but in an important sense, they are the manufacturers of money”
Basis of Credit Money
Credit money is based on bank deposits, which are categorized into two types:
1. Primary Deposits
Primary deposits arise when customers deposit cash or checks. The bank credits the customer’s account, allowing them to withdraw funds as needed. These deposits are also known as”cash deposit” or”passive deposit” as they do not create new money but convert currency into deposit money.
2. Derivative Deposits
Derivative deposits arise when a bank grants loans, discounts bills, or purchases government securities. These deposits increase the bank’s reserves and allow for further lending.
Process of Credit Creation
Customers use loans from banks to make payments, issuing checks against their deposits. The recipients of these checks deposit them in other banks, creating primary deposits for those banks. A portion of these deposits is held as reserves, while the remainder is used for lending and advances. This process, known as Multiple Credit Creation, involves multiple banks and can significantly expand the money supply.
There are two main types of credit creation:
1. Single Credit Creation
This occurs when a customer deposits funds in a bank. The bank can then lend out a portion of these funds, minus the required cash reserve ratio. For example, if a customer deposits $1,000 and the cash reserve ratio is 10%, the bank can lend out $900.
2. Multiple Credit Creation
This is the process described above, where multiple banks participate in the lending process, leading to a significant expansion of credit.
Limitations of Credit Creation
While commercial banks have the power to create credit, their abilities are not unlimited. Several factors affect the process of credit creation, including:
- Amount of Deposits: Higher deposits lead to greater credit creation.
- Cash Reserve Ratio (CRR): A higher CRR reduces the amount of funds available for lending.
- Banking Habits of People: Well-developed banking habits facilitate credit expansion.
- Supply of Securities: Loans require collateral, so the availability of securities influences credit creation.
- Willingness to Borrow: Customers must be willing to borrow for credit creation to occur.
- Monetary Policy of Central Bank: Central banks control credit creation through various methods.
- External Drain: Withdrawals of cash from the banking system can limit credit creation.
Conclusion
Credit creation by commercial banks is a complex and important process that influences the money supply and economic activity. Understanding the factors that affect credit creation is crucial for policymakers and financial institutions to manage the economy effectively.