Credit Creation by Commercial Banks ♦️

Creation of credit is an important function of a commercial bank. Prof. Sayers said “Banks are not merely purveyors of money but, also in an important sense manufacturers of money”. In a modern economy Bank’s deposits form a major proportion of total money supply.

A bank’s demand deposits arise mainly from Cash deposits by customers and Bank Loans and Investments.

👉🏻Cash Deposits By Customers

These are termed as primary deposits as they arise from the actual deposits of cash in a bank made by its customers. In receiving such deposits, the bank plays a passive role. The creation of primary deposits, however is nothing but transforming the currency money in to deposit money.

👉🏻Bank Loans And Investments:

These are termed as derivative or active deposits. The derivative deposits are lent in the form of loans or advances, discounting of bills or used for purchasing securities or other assets.

Deposit account in the name of the customer or seller, credits him with the amount of loan granted or value of security purchased, subject to withdrawl by cheque, as required. Hence loans advanced or purchases of securities creates deposits.

Thus every loan creates a deposit. They increase the quantity of bank money. The size of derivative demand deposits is determined by the banks lending and investment activities. There will be a constant inflow and outflow of cash with the banks. For the sake of liquidity and safety some proportion of total deposit must be maintained in cash, for e.g. :- 10% to 20% to meet the demand for cash at the counter. This is known as Cash Reserve Ratio.

Primary deposits serve as a basis for creating derivative deposits, that is credit creation, and for increasing money supply. Commercial banks are profit seeking institutions and when they find that large volume of cash received lies Idle, they use these resources for advancing loans or for making investment in securities, shares etc. there by earning high rate of interest. The creation of credit also depends on excess cash reserves or cash reserve ratio. The derivative deposits are used as working capital.

When the borrower withdraws money from his loan account by cheque it is deposited by the payee in some other bank. Those banks again create deposit on the basis of fresh deposits received after keeping required reserves. Ultimately, the total volume of credit or derivative deposits or bank money created by all banks would be a multiple of the original amount of new cash reserves in the system. Thus multiple expansion of credit takes place.