Credit creation

In words of Newlyn, “ Credit creation refers to the power of commercial banks to expand secondary deposits either through the process of making loans or through investment in securities.”

Concepts in credit creation Bank deposits : Can be of 2 types:-Primary or cash deposits- Amount deposited by public in bank in cash

forms. Passive deposits ( depend on depositors)Derivative or secondary deposits- It leads to credit creation. By lending loans, deposits are created.

Business Institution:Commercial institution, keen to maximize

profits by giving more loans out of primary deposits.

Cash reserve ratio: Part of total deposits kept with itself by banks.Excess reserves:Amount in excess of cash reserve ratio.

Credit Multiplier: Ratio of increase in total deposits to

increase in primary deposits. There is an inverse relation between

credit multiplier & CRR.

Assumptions of credit creation All depositors will not withdraw funds at same

time. All banks maintain CRR strictly. Banks do not pay in cash the amount

sanctioned to customers. Banks expand credit on basis of excess

reserves. People deposit funds in banks No change in credit control policy of RBI.

All banks act simultaneously Payments are made by cheques by people Commercial & industrial conditions are normal Collateral security is risk-free.

Process of credit creation Single banking system Multiple banking system

In case of single banking system

ROUND PRIMARY DEPOSIT

CRR (10%) SECONDARY DEPOSIT (LOANS)

FIRST 1000 100 900

SECOND 900 90 810THIRD 810 81 729

--- ----- ----- -----

---- ------ ------ -----

TOTAL 10,000 1,000 9,000

Credit equation & multiplier Cash reserve ratio(r)= primary deposit/

total deposits Total deposits= primary deposit in 1st round

+ secondary deposit in 2nd round + secondary deposit in 3rd round +……….. + secondary deposit in “n”th round

LIABILITIES ASSETS

PRIMARY DEPOSITS

1000 RESERVES 1000

TOTAL 1000 TOTAL 1000

LIABILITIES ASSETS

DEPOSITS 1000 RESERVES 1000

900 LOANS 900

------ -----

------- ------

TOTAL 10,000 TOTAL 10,000

In case of multiple banking system

BANKS PRIMARY DEPOSITS

CRR (10%)

SECONDARY DEPOSITS (LOANS)

A 1000 100 900

B 900 90 810

C 810 81 729

D ---- ----- -----

E ---- ----- -----

TOTAL 10,000 1,000 9,000

Limitations of credit creation Cash reserve ratio: Higher the CRR, less volume of credit

creation. Banking habits of people Credit policy of RBI Policy of other banks Availability of good borrowers Commercial & industrial conditions

Do banks really create credit????