Understanding the Credit Creation Methods by the Commercial Banks

The Main Processes followed by the Commercial Banks for Credit Creation are mentioned below:

(i) Under Monopoly Bank or Single Bank System:

To begin with, let the Cash Reserve Ratio (R) be 20%. Further, let the initial deposit (Primary Deposit, PD) made with a commercial bank by depositor ‘A’ be Rs 10,000. The commercial bank is required to retain 20% of the deposit as vault cash to encash the cheques of depositor ‘A’ and the rest, 80% of it, it lends to borrower, ‘B\ Thus, it retains only Rs 2000 (R% of PD = r. PD) and lends out the rest, Rs 8000 [(1 – R) % of PD = (1 – r).PD] to the borrower.

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Here, r = fl/100. The loan amount of Rs 8000 is credited in B’s account with the bank. This creates a secondary deposit of Rs 8000 with the bank. Borrower ‘B’ is issued a cheque book to make withdrawals from his account as and when he likes. The Total Deposit (TD) with the bank increases by Rs 8000.

The bank has to maintain another cash reserve of Rs 1600 [20% of Rs 8000 or r.(l – r)PD] for B’s cheques. The total cash reserve now is Rs 3600 (Rs 2000 for A’s cheques and Rs 1600 for B’s cheques). The bank now feels free to lend 80% [(1 – r)] of B’s deposit of Rs 8000 [(1 – r) of PD] which it lends to borrower ‘C\ This creates a third deposit of Rs 6400 [(1 – r).(l – r). PD = (1 – r)².PD] in the name of C to maintain which the bank has to retain yet another cash reserve of Rs 1280 [r.(l – rf.PD].

The total cash reserve in the bank’s vault rises to Rs 4880 (Rs 2000 for A’s cheques, Rs 1600 for B’s cheques and Rs 1280 for C’s cheques). The third deposit of Rs 6400 [(1 – r)² .PD] entitles the bank to lend 80% [(1 – r)] of it, i.e., Rs 5120 [(1 – r).( 1 – r)².PD = (1 – r)³/ PD] to some other borrower, D.

The process of lending by the commercial bank continues indefinitely until the bank is left with nothing to lend or it has the whole of the primary deposit as cash reserve in its vault. The lending process can be summarized as in Table 9.4.

The totals reached follow from the formulae:

= Rs 40,000 Required Cash Reserves = PD = Rs 10,000 The formulae 9.2, 9.3 and 9.4 follow from the sum to infinity of the geometric progression with common-ratio, = (1 – r)*

Note that the commercial bank ends up retaining the entire primary deposit as the vault cash, and at the same time, it succeeds in creating loans (credit) worth as much as Rs 40000, with total deposits rising from Rs 10000 to as high as Rs 50000. All this has been possible due people’s faith in the banking system.

Had people insisted on cash loan, the deposit in consequence to the loan would have never occurred and bank’s credit creating capacity would have been checked. Thus, highly developed banking habits play an important role in credit creation by commercial banks.

(ii) Credit Creation by Commercial Banks under Multibank System or under Competitive Banking:

The process of credit creation by commercial banks under multiple bank system differs from that in the single bank system basically in one respect—the subsequent or the derivative deposits (secondary deposits, tertiary deposits, etc.) need no longer return to the bank of the primary deposit.

Presence of other banks in the banking sector provides alternatives to public to choose from. They may choose a bank of their own convenience which need not be the bank from which they have borrowed.

The derivative deposits thus may arise in banks other than those where the primary deposits originated. But the total volume of credit generated remains unaffected. The figure below shows the flow of deposits in a multiple bank system. Suppose there are three banks— A, B and C from which a depositor has to make his choice for making his deposit.

If the bank chosen by him is bank A, the deposit made in the bank is the primary deposit if the same is the first one from this person. The first loan granted to an individual by bank A from this deposit may go to any of the three banks, including bank A. If it goes to bank A, it will form the secondary deposit, else, if it lands in bank B or bank C, it will form the primary deposit. The arrows show various possibilities for primary and derivative deposits.

The total volume of credit created by the commercial banks in a multi-bank system remains same as that in a single bank system.