The process of credit creation is considered one of the most important functions performed by a commercial bank.
The central bank of a country is responsible for ensuring the supply of money in the economy by circulating the currency. 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. Commercial banks perform the function of credit creation in an economy.
Therefore, the money that is created by commercial banks is known as credit money. This is achieved by the commercial banks in the form of purchasing securities and providing loans. The 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 provide credits from the total deposits that a bank obtains from the public. As per the rule, the commercial banks need to maintain a certain portion of the public deposits as reserves with the central bank that 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 those amounts to individuals or businesses.
Formula for determining the Credit creation
The following formula 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 us understand this with an example.
If the money deposited in a bank is ₹10,000 and the bank has a CRR of 10%, then what will be the credit multiplier coefficient?
Credit multiplier coefficient = 1/10%
Total credit creation = 10,000 ✕ 10 = 1,00,000
Similarly, if CRR = 20%
Credit multiplier coefficient = 1/20%
Therefore, total credit creation = 10,000 ✕ 5 = 50,000
From the given values we can understand that, a low CRR value results in high credit creation and a high CRR results in low credit creation. Therefore, with the help of credit creation, the money gets multiplied in the economy.
However, the commercial banks face many challenges and limitations while performing the credit creation in an economy are further discussed.
Limitations of Credit Creation
The following are some of the limitations that are experienced by the commercial banks during the credit creation process.
- Cash amount present in the bank
The higher the amount of deposits made by the public, the higher credit creation from the commercial banks can be seen. However, 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 contract or expand this limit by selling or purchasing the securities.
- Cash reserve ratio or CRR
It refers to the amount of money in the form of reserve that needs to be kept with the 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.
- Excess reserve
This takes place when a country faces recession, at that time the banks find it conducive in maintaining reserves in place of lending that leads to less credit creation.
- Currency drainage
It refers to the situation when the public is not depositing money in the banks. This results in reduced credit creation in the economy.
- Borrower availability
Credit creation will flourish if there are borrowers. The credit creation will not be done if there are no borrowers of the money in an economy.
- Prevalent business conditions
If an economy is witnessing a depression, then the businesses will not be seeking credit that leads to contraction of credit creation. Whereas, if a nation is prospering, then the businesses will seek new funds in the form of credit from the banks that would lead to credit creation.
Conditions Essential for Credit Creation
The following conditions are essential for credit creation in an economy.
- Willingness of public depositing money into the commercial banks
- Willingness of commercial banks to lend money to individuals or businesses in the form of credit
- Willingness of individuals or businesses in seeking money from the commercial banks in the form of credit
This was all about the concept of credit creation that 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.