The primary business of any commercial bank is to receive deposits from the depositors and lend money to the borrowers. In this entire process, banks cannot lend all the funds received as deposits, since they would need the money for an emergency demand by a depositor at anytime.
To meet such needs, these banks must keep some reserves, and the money which is created is called credit money.
Credit creation by commercial banks is a mandatory requirement by the central bank that decides how much credit needs to be created.
This blog aims to explain what credit creation is, how it is done, who are the key players of the credit creation process, and the problems faced by commercial banks while creating credit.
What is Credit Creation?
When a commercial bank receives any deposit from a depositor, the bank will create a deposit account in his/her name. Usually, the bank will lend money to the borrower who wants financial assistance.
However, banks are not allowed to lend all their money received from the deposits. The central bank (RBI) mandates every commercial bank to maintain a minimum level of reserve that they will use to meet the sudden demand of the depositors.
Commercial banks must keep such reserve with the central bank, and the reserve which is created is known as credit creation. It is also called credit money. The central bank issues currency in its country to perform economic transactions, while the commercial banks create credits through reserves with central bank.
How Is Credit Creation Done?
Credit creation is done based on a Cash Reserve Ratio required by the central bank to be maintained by all the commercial banks. The Credit Creation is calculated using the below formula:
Let’s get a better idea of the above formula with the help of an example:
‘Bank A’ receives INR 5,000 as a deposit which it lends to ‘Borrower A’, after keeping a CRR of 20% (INR 1,000).
‘Borrower A’ then puts INR 4,000 as a deposit into ‘Bank B’, and the bank lends that to ‘Borrower C’ after reserving 20% (INR 800) from INR 4,000.
The credit creation process goes on, and the total credit creation with the initial deposit of INR 5,000 reaches INR 25,000, provided the CRR remains constant at 20%.
|Banks||Deposit Received (INR)||Cash Reserve (CRR 20%)||Money Lent|
As we can see from the above table, the deposit created by Bank A is INR 5,000 with a cash reserve ratio of 20% by the central bank results in credit creation of INR 24,914 – 25,000 approximately.
If we use the formula of credit creation to deposit INR 5,000 with the CRR of 20%, we will also get INR 25,000 as the credit creation amount.
Credit Creation = INR 5,000 x (1 / 20%) = INR 25,000
It is important to remember that higher the CRR, lower the credit creation will be. Hence, if the CRR falls, credit creation will be more.
Key Players of Credit Creation
As explained above, the credit creation process will continue working only if there is enough demands for the deposit, loan, and advances.
The key players of the credit creation process are the depositors, lenders, and borrowers. If any one of them is missing or the demand reduces for loans or deposits, the credit creation process breaks.
6 Problems Faced By Commercial Banks During Credit Creation
When credit is being created by commercial banks, they face specific problems that make credit creation difficult. Let’s understand what these issues are.
1. Cash Reserve Ratio
Reduction in the CRR leads to more credit creation, which may harm the economy to run smoothly. Excessive credit is a threat to any nation’s economy.
2. Cash-on-Hand Limitations
The central bank determines the cash-on-hand limit for commercial banks.
As people will make more deposits, the credit creation will be more as well. However, more credit creation and the cash-on-hand limits may clash, and due to cash restrictions, banks may have to break the process.
3. Reduced Deposits
If the demand for deposits fall and people stop depositing their money into banks, there will be no credit creation, and banks will have less money to lend.
This leads to a disturbance in the process of economic transactions.
4. Economic and Business Conditions
If the economy is facing a downfall, businesses will not borrow money to survive, because there are fewer borrowers. Hence, the credit creation process breaks.
5. Declining Borrowers
When people do not prefer to borrow from commercial banks or find another alternative to borrowing money from banks, it will decline them. The declining borrowers also break the credit creation process.
6. Excessive Reserves Due to Recession
During recessions, banks would prefer to reserve money instead of lending them to borrowers. Hence, reduced lending also affects the credit creation process.
The Bottom Line
While the central bank circulates currencies in the economy, commercial banks play an essential role in credit creation.
However, if the willingness to lend money reduces, or the desire to deposit money falls, or the desire to borrow money drops, it will break the process of credit creation.