Updated: Jun 14, 2020
A bank differs from other financial institutions because it can create credit. Banks have the ability to expand their demand deposits as a multiple of their cash reserves. This is because of the fact that demand deposits of the banks serve as the principal medium of exchange, and, in this way, the banks manage the payments system of the country. Banks add to the aggregate means of payments available to the market through deposits. Broadly speaking, these deposits may be divided into two categories, namely;
– cash deposits
– credit deposits
Cash deposits refer to that form of deposits which are created when customers bring cash to a bank and deposit the same with it. In this process, the public finds that there is no net addition to the means of payments possessed by it. There is only a change in their form; that is, some cash is replaced by bank deposits. Cash deposits may also be referred to as primary deposits.
The other category of deposits is more important for our purpose. A bank is a financial institution and has the objective of earning a profit income. Its main source of operating surplus is the difference between interest paid on its liabilities and interest earned from its assets. Cash balances appear on the asset side of its balance sheet. But it cannot earn any interest income from them. It must acquire other income earning assets for this purpose. It finds that the maximum income which it can earn is from the loans and advances given by it to its customers or borrowers. However, loans extended by a bank to its borrowers result in the creation of deposits in favour of the borrowers and thus add to the means of payment with them. The loan deposits so created are termed secondary deposits or derived deposits. Numerically, the addition to money supply is equal to excess of its deposit liabilities over its cash holdings. Since this addition takes place via loan-giving activity of the bank, the process is known as that of credit creation.
The fact of credit creation by banks can be verified both with the help of theory and their balance sheets. As stated above, a bank is a financial firm and has the objective of earning a profit income. For this reason, therefore, a bank “borrows short and lends long.” In other words, it contracts liabilities which, on an average, have a shorter duration and it acquires assets which, on the average, have a longer duration. Its assets are dominated by the category of “loans and advances” which bring a high interest income to the bank. Its liabilities are dominated by its deposit liabilities some of which are interest free while the rest of them carry comparatively low interest rates. Therefore, the bank is interested in creating the maximum possible deposit liabilities (preferably of the demand deposit variety).
The fact of credit creation can also be verified by looking at the balance sheet of any bank. It is seen that the cash balances with the bank are always a fraction of its deposit liabilities. As a result, the bank provides the market a much larger amount of means of payment (in the form of bank deposits) than it takes away from it (in the form of cash balances).
Process of Credit Creation
Credit creation is one of the important functions of a commercial bank. It constitutes the major component of money supply in the economy. The process of ‘Credit Creation’ begins with banks lending money out of primary deposits. Primary deposits are those deposits which are deposited in banks. Since, banks cannot lend the entire primary deposits so they are required to maintain a reserve with RBI which constitutes a certain proportion of primary deposits as per RBI Act & Banking Regulation Act. After maintaining the minimum required reserves, the bank may lend the remaining portion of primary deposits to borrowers. As banks lend the money, the process of credit creation commences.
Customers use these loan amounts to make payments. While making payments, they issue a Cheque against the loan deposits. The person who receives the Cheque, deposits it in another bank or same bank. For that bank, this would account as the primary deposit. A proportion of this deposit would be kept as a reserve and the balance will be used for lending further loans and advances. This process is repeated by other banks. This is how credit process is created.
During the process of credit creation, there arise two important issues which hold utmost consideration, namely profitability and liquidity.
– Profitability: Banks are guided by the profit earning motives in its operations. So the loans granted must
be in a manner which earns an interest higher than what banks pay on its deposits.
– Liquidity: Banks on the other hand, subsequently should be able to meet its commitment to pay cash to its depositors as and when the depositors decide to exercise their right to demand cash against their deposits.
The bank credit creating process is based on the assumption that during any given time interval, only a fraction of its customers will be in genuine need of cash and that all customers would not turn up for demanding cash against their deposits at one point of time. At any given time, only a fraction of total deposits would be used to pay cash. Therefore, banks can lend the remaining proportion of money into market thereby, creating credit.
The net result is that a bank is able to meet the demand for encashment by its depositors by maintaining cash reserves which are only a fraction of its deposit liabilities. This phenomenon is known as that of “fractional cash reserves”, or “cash deposit ratio” being less than one.
In other words, the bank is subject to pulls from two opposite directions. The objective of profitability dictates that the bank should create additional deposits by giving loans to its customers and thus reduce the cash deposit ratio. The objective of liquidity dictates that the bank should be able to meet the demand for cash by its depositors and therefore maintain a very high cash deposit ratio. Accordingly, the bank tries to maintain that cash deposit ratio which is able to meet both requirements in a balanced manner.
Steps in the Process of Credit Creation
Assumptions to the process for simplification:
– There is only one bank named B, in the market.
– All deposits of cash and Cheques are made through this bank only.
– Cash Deposit Reserve maintained by bank is R%. i.e.
Cash Reserves X 100 = R %
– There is no net cash leakage. It means that the cash withdrawn by depositors is returned to it by the
customers in the form of fresh deposits.
– The initial deposit with the bank is C = A100/=
Case 1: One Bank – No Cash Leakage
With the above assumptions, we find that the bank B starts with an deposit liability of Rs. 100 matched by an initial cash balance of Rs. 100. However, once the use of bank deposits by bank clients settles into a routine, the bank finds that, per period of time, there is an outflow of Rs. 10 matched by an equivalent inflow of cash of Rs. 10. As a result, the bank management discovers that it has a surplus of Rs. 90 which can be used for acquiring some income earning asset. Therefore, when borrowers apply for loans, the management is able to lend them Rs. 90.
As it does so, it acquires an asset termed ‘loans and advances’ worth A 90 and simultaneously contracts an additional deposit liability of Rs. 90. This is the second round of deposit creation and first round of credit creation. At the end of the second round of deposit creation, the bank has assets of A 190 (cash A 100 plus loans and advances Rs. 90) matched by liabilities of Rs. 190 (cash deposits Rs. 100 plus loan deposits, or credit creation, of Rs. 90).
When the circulation of deposits of A 190 settles to a routine affair, the bank finds that out of its cash reserves of Rs. 100, only Rs. 19 (A 10 + A 9) are in circulation and it has a spare balance of A 81 left with it. Consequently, the third round of deposit creation (and the second round of credit creation) brings in deposit liabilities of A 81. In this manner, the bank B keeps creating deposits by giving loans. But it does so in stages and not in one step. When the process of credit creation is completed, the deposit liabilities of the bank stand at Rs. 1000 out of which Rs. 900 are due to the credit creation. It means that by losing Rs. 100 in the form of cash, the market has acquired means of payment, totaling Rs. 1000, in the form of bank deposits. There is a net addition of Rs. 900 to the money supply, or means of payments, in the hands of the market and this corresponds to the loans (Rs. 900) given by the bank in several rounds of deposit creation.