Answer:
Credit creation refers to the ability of the commercial banks to multiply loans and advances by creating deposits. Commercial banks create credit by advancing loans and purchasing securities.
The money lent to individuals and businesses comes from deposits of the public held by these banks. The banks are required to reserve a certain portion of these deposits with it, to serve cash requirements of depositors and lend only the remaining portion of public deposits.
Mechanism of credit creation:
Suppose a customer of Bank X deposits an amount of Rs. 1000 in this bank. Bank X keeps a cash reserve of 20 per cent, i.e. Rs. 200 and uses the excess reserve i.e. Rs. 800 in advancing loan to one of its customers by opening an account in his name. This borrower from Bank X uses this amount in buying goods from some trader and makes payment by drawing a cheque on Bank X. Suppose this
trader has his account in Bank Y. It will deposit this cheque of Rs 800 in Bank Y to be collected from Bank X.
Thus, Rs. 800 will be transferred from Bank X to Y. Bank Y also keeps 20 per cent, i.e. Rs. 160 and is left with an excess reserve of Rs 640, which it lends to another customer. Another such transaction, say with Bank Z, will leave it with Rs. 512. Thus an initial deposit of Rs. 1000 has resulted in the creation of deposits by three banks amounting to Rs. (1000+800+640+512) = Rs. 2952. This is how
the entire banking system will be able to create new deposits and hence credit creation happens.
The bank’s credit creation process is based on the assumption that during any time interval, only a fraction of its customers genuinely need cash. Also, the bank assumes that all its customers would not turn up demanding cash against their deposits at one point in time.
Factors limiting credit creation:
Higher the cash with the commercial banks in the form of public deposits, more will be the credit creation.
The cash reserve ratio affects the credit creation. The lower is the ratio, the greater is the ability to create credit.
The process of credit creation gets started only when borrowers come to a bank for loan purposes. So, the number of reliable borrowers affects the credit creation.
A commercial bank lends money against accepted securities. 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 credit creation process may suffer from cash leakages in the form of excess reserves or currency drain.
Business conditions of the banks like inflation, depression, etc. also affect the credit creation process.
