The process of credit creation is said to be one of the most important of the functions that are performed by a commercial bank.
The central bank of a country is responsible for ensuring money supply in the economy by currency circulation. It also ensures that for fulfilling all the transactions, there should be appropriate currency in the system.
This process cannot be implemented by the central bank alone, for this they require the help of commercial banks and their reserves. The commercial banks perform the function of credit creation in an economy.
Therefore, the money that is created by the commercial banks is called credit money. This is achieved by the commercial banks in the form of providing loans and purchasing of securities. Commercial banks facilitate the loans by utilising the deposits that are obtained from the public.
There are restrictions on the amount of money that can be provided as credit from the total deposits that a bank obtains from the public. As per the rule, commercial banks need to maintain a certain portion of the public deposits as reserves with the central bank which will be used for meeting the immediate cash requirements of the depositors.
Only after keeping aside the required amount of those reserves, the commercial banks are permitted to lend to individuals or businesses.
Formula for determining the Credit creation
The following formulae can be used to determine the total credit creation
Total Credit Creation = Original Deposit ✕ Credit Multiplier Coefficient
Credit multiplier coefficient= 1 / r
r = Cash reserve requirement also known as Cash Reserve Ratio (CRR)
Let’s understand this with an example
If the money deposited in bank is Rs.10000 and the bank has a CRR of 10%, then Credit multiplier coefficient will be
Credit multiplier coefficient = 1 / 10%
= 1/ 0.1
Total Credit Creation = 10000 ✕ 10 = 100000
Similarly, if CRR = 20 %
Credit multiplier coefficient = 1 / 20%
= 1/ 0.2
Total Credit Creation = 10000 ✕ 5 = 50000
From the above values we can see that lower the CRR value, higher will be the credit creation and higher the CRR, lesser will be the credit creation. Therefore, with the help of credit creation, money gets multiplied in the economy.
However, commercial banks face many challenges and limitations while performing the credit creation in an economy which is discussed below.
Limitations of Credit Creation
Following are the limitations that are experienced by the commercial banks during the credit creation process
1. Cash amount present in bank
The higher the amount of deposits made by the public, the higher will be the credit creation from commercial banks, but there is a certain limit on the amount of cash that can be held by the banks at a time.
This limit is determined by the central bank, as the central bank may expand or contract this limit by selling or purchasing the securities.
2. Cash Reserve Ratio or CRR
It refers to the amount of money in form of reserve that needs to be kept with central banks by the commercial banks. This amount is used for meeting the cash requirements of the users. Any fall in the CRR will lead to more credit creation.
3. Excess Reserve
This takes place when a country faces recession, at that time banks find it conducive to maintain reserves instead of lending which leads to less credit creation.
4. Currency Drainage
It refers to the situation when the public does not deposit money in the banks, which results in reduced credit creation in the economy.
5. Borrower Availability
Credit creation will flourish if there are borrowers, there will be no credit creation if there are no borrowers of the money.
6. Prevalent business conditions
If an economy is witnessing a depression then the businesses will not be seeking credit which leads to contraction of credit creation. Whereas, if a nation is prospering then businesses will seek new funds in the form of credit from the banks which leads to credit creation.
Conditions essential for Credit Creation
The following conditions are essential for credit creation in an economy
- Public depositing money into the commercial banks
- The willingness of commercial banks to lend money to individuals or businesses in the form of credit.
- The willingness of individuals or businesses in seeking money from commercial banks in the form of credit.
This was all about the concept of credit creation which plays an important role in the economy of a nation. For more such interesting concepts on Economics for Class 12, stay tuned to BYJU’S.