credit creation in commercial

7/27/2019 Credit Creation in Commercial

1/12

Credit Creation in commercial banks


2/12

Credit creation of commercial banks

The commercial banks are the second most important sources

of money supply. The money that commercial banks supply is

called credit money.

The process of Credit Creation begins with banks lending

money out of primary deposits. Primary deposits are those

deposits which are deposited in banks.

After maintaining the required reserves, the bank can lend the

remaining portion of primary deposits. Here banks lend the

money and the process of credit creation starts.


3/12

Process of Credit Creation. Suppose there are a number of Commercial Banks in the Banking System

Bank 1, Bank 2, Bank 3, & So on.

To begin with let us suppose that an individual A makes a deposit of Rs.

100 in bank 1. Bank 1 is required to maintain a Cash Reserve

Requirement of 5% which is decided by the RBIs Monetary Policy from

the deposits made by A.

Bank 1 is required to maintain a cash reserve of Rs. 5 (5% of 100). The

bank has now lendable funds of Rs. 95(100 5). Let the Bank 1 lend Rs.

95 to a borrower; say B. the method of lending is the same that is bank 1opens an account in the name of the borrower for the loan amount. At

the end of the process of deposits & lending, the balance sheet of bank

read


4/12

S.No Liabilities Amount Assets Amount

01 A deposits 100.00 Cash

Reserve

5.00

Loan to B 95.00

S.No Liabilities Amount Assets Amount

01 B deposits 95.00 Cash

Reserve

4.75

Loan to C 90.25

Bank 1

Bank 2


5/12

Bank Liabilities Assets Reserves TotalAsset

Bank 1 100.00 95.00 5.00 100.00

Bank 2 95.00 90.25 4.75 95.00

Bank 3 90.25 85.73 4.52 90.25

The process will continue until the reserve with the banks isreduced to Zero

Total 2000 1900.00 100.00 2000.00


6/12

Deposit multiplier.

The total deposit created by the commercial banks constitutes themoney supply by the banks. Credit creation of commercial banksdepends upon deposit multiplier.

Deposit multiplier = 1/r-where r is CRR, (5%) or 1/0.05or 20

In the example primary deposit is Rs. 100/- Deposit

multiplier is 20. Hence total credit creation of commercialbanks equal to 100 x 20 = 2,000.


7/12

7

If depositors or borrowers choose to hold their

money in cash instead of depositing, this slows

down the money creation process.What percentage of deposits and bank loans do

depositors and borrowers want to hold as cash

instead of holding them in their accounts?We assumed 0%. In reality, this is positive.


8/12

Money multiplier in reality is smaller than

1/r.

For example, while r is around 10% on

average in a country, money multiplier maybe around 7, not 10.

The deposit multiplier or Money Multiplier

can be reduced by increasing the CRR. If CRR

is 10%,the money multiplier may be

10.(1/0.10)


9/12

The chain of multiple deposit creation


10/12

The RBI employs four measures of

money stock, namely M1, M2, M3 and

M4.


11/12

M1: This is the money supply ie the currency with the public

and demand deposits with the bank and other deposits withRBI.

In developed countries demand deposits form a major part

of the money supply.

Demand deposits are primarily savings and current

account deposits where your are able to "demand" your

money at any time, unlike a term deposit, which cannot be

ordinarily accessed for a predetermined period.


12/12

M2: M1+Post Office Savings

M3 or aggregate money supply: M2 + Time Deposits

with the banks.

M4: M3+total Post office deposits other than NSC

credit creation in commercial

Documents