Question

How do commercial banks create credit? Explain with the help of an example.

Answer 1

Money/credit creation is an important function of the commercial banks. By creating credit, commercial banks contribute to money supply in the economy.They create credit in the form of demand deposits.

Demand deposits of the commercial banks are many times more than their cash reserves.

If cash reserves are (say) RS 1,000 and if the demand deposits are (say) RS 10,000, then the commercial banks are creating credit ten times of their cash reserves. Accordingly, on the basis of cash reserves of RS 1,000, the commercial banks are contributing RS 10,000 to the supply of money. The process of credit creation is like this: Initially, bank receives deposits of RS 1,000.

The required reserves to tackle the liability of RS 1,000 is equal to RS100 (on the assumption that cash reserve ratio is 10% of total deposits). Implying that the banks have excess reserves = RS 1,000 – RS100 = RS 900 which they can use for the purpose of lending. When these excess reserves are loaned out, total deposits of the bank amount to RS 1000 + RS900 = RS 1,900. The banks need to hold cash reserves as 10% of RS 1,900 or RS 190, while their actual reserves are RS1,000. Implying excess reserves of RS 1,000 – RS190 = RS810 can be loaned.

This process continues till total demand deposits are RS 10,000 and cash reserves are RS1,000. Thus, if required reserve ratio is equal to 10%, total cash reserves of RS 1,000 allow the bank to create demand deposits up to RS10,000.

Here, it is important to note that loans are never offered in cash. These are always reflected as demand deposits in favour of the borrowers. Accordingly, when loans are offered, demand deposits of the banks lend to build up. In the above example, cash reserves of RS 1,000 allow demand deposits of RS 10,000 which serve as a source of money supply.