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Question
Commercial banks can create credit on the basis of primary deposit. Explain.
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Solution
The main source of funds for commercial banks, is the deposits from the public. Banks are said to be "manufacturers" of money. They accept deposits called primary deposits from the public. These deposits form the basis of all credit creation activities. It is one of the most significant tasks performed by all commercial banks. Commercial banks create deposits while granting loans. Banks grants loans from the deposits (Primary). A part of these deposits are kept as reserve by the bank to meet the demand for cash by the depositor. This is termed as minimum cash reserve.
The balance over the minimum cash reserve is used by the banks to create credit by way of providing loans is known as derivative deposits. In other words, derivative deposit is a deposit which is left over after deducting cash reserves from primary deposits. When a bank grants loan to a borrower, bank opens a deposit account in the name of the borrower and credit the loan amount in this account. This is called Derivative deposit. Borrower can withdraw money from this account by means of cheque. So it is said that "Every loan creates a DEPOSIT". This act of creating deposits while granting loans of all banks taken together leads to multiple credit creation.
When the borrower withdraws money from his loan account by cheque it is deposited by the payee in some other bank. These bank again create credit on the basis of fresh deposits received after keeping the required reserves. In this way commercial bank creates credit money which is the part of total money supply. So commercial banks are also known as manufacturer of money.
The banking system can expand its loans and investments by many times of the primary deposits amount received by it. The amount from repaid loans can the further used to sanction additional loans. This process is called as Multiple Credit Creation (MCC).
In short, credit creation can be defined as the expansion of bank deposits through the process of more loans and advances and investments.
The balance over the minimum cash reserve is used by the banks to create credit by way of providing loans is known as derivative deposits. In other words, derivative deposit is a deposit which is left over after deducting cash reserves from primary deposits. When a bank grants loan to a borrower, bank opens a deposit account in the name of the borrower and credit the loan amount in this account. This is called Derivative deposit. Borrower can withdraw money from this account by means of cheque. So it is said that "Every loan creates a DEPOSIT". This act of creating deposits while granting loans of all banks taken together leads to multiple credit creation.
When the borrower withdraws money from his loan account by cheque it is deposited by the payee in some other bank. These bank again create credit on the basis of fresh deposits received after keeping the required reserves. In this way commercial bank creates credit money which is the part of total money supply. So commercial banks are also known as manufacturer of money.
The banking system can expand its loans and investments by many times of the primary deposits amount received by it. The amount from repaid loans can the further used to sanction additional loans. This process is called as Multiple Credit Creation (MCC).
In short, credit creation can be defined as the expansion of bank deposits through the process of more loans and advances and investments.
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