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Credit Creation By Commercial Banks

 Credit Creation by Commercial Banks

Introduction

The creation of credit or deposits is one of the most vital operations of the commercial banks. Similar to other corporations, banks aim at earnings profits. For this intention, they accept cash in demand deposits and advance loans on credit to customers. When a bank advances funds, it does not pay the amount in currency notes. However, it introduces a current account in the name of the investor and lets him to withdraw the necessary amount by cheques. By this way, banks create deposits or credit.

Demand deposits mount in two ways:

  • When the customer deposits currency with commercial banks, and

  • When banks advance loans, discount bills, provide overdraft facilities and make deposit investments through bonds and securities.

The first type of demand deposits is termed “primary deposits”. Banks play a passive play in introducing them.

The second type of demand deposits is termed as “derivative deposits”. Banks actively create deposits.

As per Withers,

Banks can generate credit by introducing a deposit, every time they advance a loan.

  • This is for the reason that every time a loan is sanctioned, imbursement is made through cheques by the customers.

  • All such imbursements are regulated through the clearing house.

  • As long as the loan is due, a deposit of that amount remains pending in the books of the bank.

  • Thus every loan creates a deposit; however, this is an overstated and tremendous outlook.

Dr.Leaf and practical bankers do not agree with this outlook. As per them,

  • They go to the contra intense.

  • They hold that banks cannot create money out of skinny air.

  • They can lend only what they have in cash.

  • Hence, they cannot and do not create funds.

The Progression of Credit Creation

Now let us see the real progression of credit creation.

A bank can lend parity to its surplus reserves. However, the whole banking system can lend and create credit up-till a multiple of its nominal surplus funds deposits.

The deposit multiplier is based upon the required reserve which is the foundation of credit creation.

Metaphorically, the required reserve ratio is given as:

RRr     =          RR
                         D

Or                    RR       =          RRr x D

Where RR is the required cash reserves with banks, RRr is the required reserve ratio and D is the demand deposits of banks.

To represent that D is based on RR and RRr, we have divide both sides equally by RRr like the following:

                        RR       =          RRr x D
                        RRr                    RRr

Or                    RR       =          D
                        RRr

Or                      1        =               
                        RRr                 RR

Or                    D         =            1        x RR
                                                RRr

Where 1 / RRr, is the reciprocal of the percentage ratio and is termed as the deposit expansion multiplier. It ascertains the bounds of the deposit expansion of a bank.

The optimum amount of demand deposits which the banking system can support with any specified value of RR is by applying the multiplier to RR.

Taking the original variation in the amount of deposits (ΔD) and in cash reserves (ΔRR), it follows from any specified percentage of RRr.

ΔD       =          RR       x            1       
                                                RRr

To know more, let us see a small illustration.

Illustration 53

Presume RRr for the banks is fixed at 10 percent and the initial variation in cash reserves is $ 2000.

Determine the maximum increase in demand deposits with using the above formula.

Solution:

ΔD       =          2,000 x    1     
                                      0.10

            =          $ 20,000

This is the extent to which the banking system can create credit. The above equation can also be expressed as follows:

ΔD       =          RR (1 + (1-RRr) + (1-RRr)^2 + ……. + (1-RRr)^1

The sum of the arithmetic progression within bracken specified:

          1            =            1       
1 – (1-RRr)                  RRr

            ΔD                   =          ΔRR x    1          
                                                             RRr

The deposit enlargement multiplier rests on the postulations that banks lend out all their surplus and RRr remains invariable.

To describe the procedure of credit creation, we make the succeeding postulations.

  1. There are many banks say A, B, C etc in the banking system.
  1. Each bank has to hold 10% of its deposits in reserves. In other words 10 % is the required ratio fixed by statute.
  1. The first bank has $2000 as deposits.
  1. The loan amount drawn by the customer of one bank is deposited in full in the second bank and that of the second bank into the third bank and so on.
  1. Each bank begins with the nominal deposit which is deposited by the debtor of the other bank.

Illustration 54

Based on the above postulations, presume that Bank M receives a cash deposit of $2000 to commence with. This is the cash in hand with the bank which is its assets and this amount is also the liability of the bank by way of deposits it holds.

Given the reserve ratio of 10 % the bank holds $200 in reserves and lends $1800 to one of its customers who in turn, gives a cheque to some person from whom he borrows or buys something.

The net changes in bank ‘M’ in balance sheet are (+ve) $200 in reserves and (+ve) $1800 in loans on the assets side and $2000 in demand deposits on the liabilities side as represented in the below Tablet (1).

Prior to these variations Bank M had zero surplus reserves.

Assets

Liabilities

Reserves

$2000

Deposits

$2000

 

Net changes

 

Net changes

Reserves

$200

Deposits

$2000

Loans

$1800

   
  • This variation of $1800 is deposited by the customer in Bank N whose balance sheet is represented in Table (2).

  • Bank B starts with a deposit of $1800, holds 10% of it or $180 as cash in reserve.

  • Bank B has $ 1620 as surplus reserves which it lends thereby creating new deposits.

Assets

Liabilities

Reserves

$1800

Deposits

$1800

 

Net changes

 

Net changes

Reserves

$180

Deposits

$1800

Loans

$1620

   
  • This loan of $1620 is deposited by the customer of Bank N into Bank O.

  • The balance sheet of Bank O is represented in Table (3)

  • Bank O keeps $162 or 10 % of $1620 in cash reserves and lends $1458

Assets

Liabilities

Reserves

$1620

Deposits

$1620

 

Net changes

 

Net changes

Reserves

$162

Deposits

$1620

Loans

$1458

   
  • This procedure goes on to other banks. Each bank in the sequence gets surplus reserves, lends and creates new demand deposits equal to 90 % of the prior bank.

  • By this way, new deposits are created to the tune of $20000 in the banking system as shown in the tablet (4).

Bank

Required Reserves

New Loans

New Deposits

M

$200

$1800

$2000

N

$180

$1620

$1800

O

$162

$1458

$1620

All other Banks

$1458

$13122

$14580

Total for the Banking System

$2000

$18000

$20000

The multiple credit creation represented in the last column in the Table (4) can also be worked out arithmetically as:

$2000 (1 + (9/10) + (9/10)^2 + (9/10)^3 + ….+ (9/10)^n)

=          2000 (1/1-910)            =          2000 (1/1/10)  

=          2000 x 10                    =          20000             


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