Credit Creation by Banks

Credit Creation by Banks

By

Amit Panwar
MBA in Finance
Pune University

Central bank is the first source of money supply in the form of currency in circulation. The Reserve Bank of Indian is the note issuing authority of the country. The RBI ensures availability of currency to meet the transaction needs of the economy. The Total Volume of money in the economy should be adequate to facilitate the various types of economic activities such as production, distribution and consumption.

The commercial banks are the second most important sources of money supply. The money that commercial banks supply is called credit money.

The process of 'Credit Creation' begins with banks lending money out of primary deposits. Primary deposits are those deposits which are deposited in banks. In fact banks cannot lend the entire primary deposits as they are required to maintain a certain proportion of primary deposits in the form of reserves with the RBI under RBI & Banking Regulation Act. After maintaining the required reserves, the bank can lend the remaining portion of primary deposits. Here bank's lend the money and the process of credit creation starts.

Suppose there are a number of Commercial Banks in the Banking System – Bank 1, Bank 2, Bank 3, & So on.

To begin with let us suppose that an individual "A" makes a deposit of Rs. 100 in bank 1. Bank "1" is required to maintain a Cash Reserve Requirement of 5% (Prevailing Rate) which is decided by the RBI's Monetary Policy from the deposits made by 'A'. Bank "1" is required to maintain a cash reserve of Rs. 5 (5% of 100). The bank has now lendable funds of Rs. 95(100 – 5). Let the Bank "1" lend Rs. 95 to a borrower; say B. the method of lending is the same that is bank 1 opens an account in the name of the borrower cheque for the loan amount. At the end of the process of deposits & lending, the balance sheet of bank reads as given below:-

Balance Sheet of Bank "1"

Liabilities	Amount	Assets	Amount
A's deposits	100	Cash Reserve	5
		Loan to "B"	95
Total	100	Total	100

Now suppose that money that borrowed from bank "1" is paid to individual "C" in settlement of his past debts. The individual "C" deposits the money in his bank say, bank 2. Now bank 2 carries out its banking transaction. It keeps a cash reserve to the extend of 5%, that is Rs. 4.75 (5% of 95) and lend Rs. 90.5 to a borrower D. at the end of the process the balance sheet of Bank 2 will be look like:-

Balance Sheet of Bank "2"

Liabilities	Amount	Assets	Amount
B's deposits	95	Cash Reserve	4.75
		Loan to "C"	90.5
Total	95	Total	95

The amount advanced to D will return ultimately to the banking system, as described in case of B and the process of deposits and credit creation will continue until the reserve with the banks is reduced to zero. The final picture that would emerge at the end of the process of deposit & credit creation by the banking system is presented in the consolidated balance sheet of all banks are as under:-

The combined Balance sheet of Banks

Bank	Liabilities Deposits	Assets Credits	Reserve	Total Assets
Bank 1	100	95	5	100
Bank 2	95	90.5	4.75	95
Bank 3	90.5	85.98	4.52	90.5
-	-	-	-	-
-	-	-	-	-
Bank n	00	00	00	00
Total	2,000	1,900	100	2,000

It can be seen from the combined balance sheet that a primary deposits of Rs. 100 in a bank 1 leads to the creation of the total deposit of Rs. 2,000. The combined balance sheet also shows that the banks have created a total credit of Rs. 2,000. And maintained a total cash reserve of Rs.100.Which equals the primary deposits. The total deposit created by the commercial banks constitutes the money supply by the banks.

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.

Amit Panwar
MBA in Finance
Pune University

Source: E-mail June 2, 2009