The creation of credit or deposits is one of the most important functions of commercial banks. Credit creation is a process in which expansion of bank deposits takes place along with the investments in the form of loans and advances. Like other companies, the banks also aim at earning profits. For this purpose, they accept cash in demand deposits and advance loans on credit to customers. According to R.S.Sayers, “Banks are not merely purveyors of money but also manufacturer of money”.
The bank loan is not paid directly to the borrower but is only credited to his account and allows him to withdraw the required cash. Every loan creates its own deposits in the bank., So. the credit is created by the bank by expanding its deposits.
The bank deposits are created in two ways. They are as follows:
- Primary Deposits: This type of deposit is created when the bank accept deposits from the public. The primary deposits act as base for providing loans to the public.
- Derivative Deposits: These deposits arise when banks lend loans to customers. The bank loan is not paid directly to the borrower but is only credited to his account and allows him to withdraw the required cash. So, whenever a loan is granted, derivative deposit is created by the bank.
Credit creation by commercial Banks: The process of credit creation starts with banks lending money from primary deposits. Banks lend money after keeping certain portion of primary deposits in the form of reserves as per the directions of the Central Bank. The following assumptions are assumed to illustrate the process of credit creation by commercial banks.
- Existence of many banks in the country.
- Every bank has to maintain 10% cash reserve.
- Initial deposit of Rs. 1000 is made by the customer into the bank.
- Existence of banking habits.
with the above assumptions, if a Canara Bank receives Cash deposits of Rs.1000 from a customer. Given the reserve ratio of 10%, the bank keeps Rs. 100 in reserves and provide loan of Rs.900 to Mr.A. The balance sheet of Canara Bank will be as
When Canara bank lends Rs.900 to Mr.A, he may deposit it with the same bank or some other bank. If the deposits Rs.900 with Vijaya Bank, then Vijaya Bank receives Rs.900 as initial deposit called Primary deposit. By keeping 10% reserve i.e., Rs.90, it can lent Rs.810 to Mr.B. Then the balance sheet of Vijaya Bank will be as follows:
Thus the process will continue till the primary deposit of Rs. 1000 is fully used in the process of credit. The cash deposit of Rs. 1000 results in a derivative deposit of Rs.900+810+………and so on. The following table shows the whole banking system’s credit creation activity:
