Credit Creation by Commercial Bank: Limitations of Credit Creation

One of the most important functions of a commercial bank is the creation of credit. In this article, we will explore this credit creation function of a commercial bank and also look at some of its limitations.

Credit Creation by a Commercial Bank

A commercial bank is a dealer of credit. It creates money based on cash deposits. Further, it issues new money through its loan operations and creates credit or expands the monetary base of a country.

Therefore, this process of credit creation leads depositors to believe that they have money with the bank. Also, borrowers believe that they owe a certain amount of money to the bank. Let’s understand credit creation through an example.

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Example:

Let’s say that a bank receives a sum of Rs.1,000 as a demand deposit. Also, let’s assume that the Cash Reserve Ratio (CRR) is 20%.

Therefore, the bank retains Rs.200 and lends the remaining Rs.800 to a borrower. While the depositor claims that he has Rs.1000 with the bank, the borrower has Rs.800 too.

Therefore, a single bank manages to create a credit of Rs.800.

If we extend this example to the entire banking system, then it offers an interesting insight.

Let’s say that the borrower takes a loan of Rs.800 from Bank A and deposits it with another bank (Bank B). Bank B retains 20% of the deposited amount (Rs.160 = 800×20%) and lends the remaining Rs.640 to another borrower.

Further, let’s say that the second borrower deposits the loan amount of Rs.640 with Bank C. This bank also retains the CRR of 20% (Rs.128 = 640×20%) and lends the remaining Rs.512 to the third borrower. This process continues until the time that the deposited sum is nearly equal to the CRR.

Just to give you a perspective, a single deposit of Rs.1000 with a CRR of 20% (1/5th) leads to the credit creation of Rs.5000. Therefore, the size of the multiplier is 5 (1000×5 = 5000).

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Learn more about Principles of Commercial Bank here in detail.

Limitations of Credit Creation

The multiple credit creation process, as explained in the example above, depends on various factors:

A lot depends on the Cash Reserve Ratio (CRR). In fact, there is an inverse relationship between the CRR and the size of the multiplier. Therefore, if the CRR is 100%, then the bank cannot create credit.
What happens when a society is in an economic depression? People stop taking loans. If a bank cannot lend, then it cannot create credit. In other words, the credit creation depends on the amount of loan that a bank grants.
The size of the cash deposit is an important factor too. If a bank has a smaller cash base, then it has a lesser scope for creating credit.
A commercial bank lends money against accepted securities. The bank specifies the securities against which it offers loans. Also, the value of the securities must be equal to the amount of the loan. Even if the bank has a large cash base for creating credit, it will not lend money if it does not get acceptable security.
The Central Bank (Reserve Bank of India) substantially control the credit-creating power of all commercial banks. It has certain instruments which enable it to increase or decrease the volume of credit creation. Further, it also controls the direction and purpose of credit that the banks offer. All banks accept the regulations of the Central Bank as it is their lender of last resort.

Solved Question

Q1. What is credit creation by commercial banks?

Answer: Commercial banks can expand the deposits they receive through loans, resulting in an expansion of the monetary base of a country. This is credit creation.

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