Credit creation by commercial banks

1. Meaning

Credit creation is the power of commercial banks, as a system, to expand demand deposits to a multiple of the cash reserves they hold. Banks know that depositors do not all withdraw at once, so they keep only a fraction of deposits as cash reserves and lend the rest. The loan is not usually paid out in cash; it is credited to the borrower’s account, and when the borrower pays others by cheque, the money returns as a deposit to some bank, which in turn lends it again. Hence the saying “loans make deposits”.

Sayers: banks are “not merely purveyors of money, but also in an important sense manufacturers of money.”

2. Primary and derivative deposits

• Primary (passive) deposits arise when customers deposit cash or cheques drawn on other banks. They add to the bank’s cash; the bank does not create them.
• Derivative (active) deposits arise when a bank grants a loan or buys a security and credits the amount to the borrower’s account. These are created by the bank and are the essence of credit creation.

3. Assumptions

1. Banks keep a fixed cash reserve ratio (r) against deposits, by law or convention.
2. There is no cash leakage: all payments are made by cheque and all money stays in the banking system.
3. Banks keep no excess reserves: they lend everything above the required reserve.
4. There is enough demand for loans from creditworthy borrowers.
5. There are many banks, or one bank with many branches.

4. The process: worked example

Let the reserve ratio r be 10 per cent and let Mr. X deposit Rs. 1,000 in cash in Bank A.

Bank A keeps Rs. 100 and lends Rs. 900 to Y; Y pays Z, who deposits the cheque in Bank B; Bank B keeps Rs. 90 and lends Rs. 810; and so on. The deposits form a geometric series 1,000 + 900 + 810 + 729 + ... whose sum is 1,000 / (1 − 0.9) = Rs. 10,000.

Formula. Total deposits D = initial deposit × 1/r = 1,000 × 1/0.1 = Rs. 10,000. The credit multiplier is 1/r = 10. Of the total deposits, Rs. 1,000 is the primary deposit and Rs. 9,000 is created credit (derivative deposits), exactly matched by Rs. 9,000 of loans; the original Rs. 1,000 of cash is now held as reserves spread across the banks.

If r rises to 20 per cent, the multiplier falls to 5 and total deposits to Rs. 5,000. This is why a higher cash reserve ratio is a tool of credit contraction.

With cash leakage

If borrowers keep part of each loan in cash, less returns to the banks. Let banks keep r = 10 per cent and the public withdraw c = 10 per cent of each deposit as cash. Each round, the next deposit is (1 − r)(1 − c) = 0.9 × 0.9 = 0.81 of the previous one. Total deposits = 1,000 / (1 − 0.81) = 1,000 / 0.19 = about Rs. 5,263, not Rs. 10,000. Leakages sharply reduce credit creation.

A single bank versus the banking system

A single bank in a multi-bank system cannot lend more than its excess reserves, because the cheques drawn by its borrowers will be deposited in other banks and it will lose cash to them. Credit creation is therefore a power of the banking system as a whole. A monopoly bank with all depositors as customers could, however, create the full multiple at once, because all cheques come back to it.

5. Limitations of credit creation

1. Amount of cash in the banking system: more cash, more credit.
2. Cash reserve ratio: the higher the ratio, the smaller the multiplier. The RBI fixes the CRR under section 42 of the RBI Act and the SLR under section 24 of the BR Act; both reduce the funds available for lending.
3. Banking habits of the people: where people prefer cash to cheques, leakages are large. Digital payments have reduced this leakage.
4. Leakages: cash drain and excess reserves kept by cautious banks.
5. Availability of good security: banks lend only against sound security.
6. Demand for loans: in a depression businesses do not borrow even at low rates; banks cannot force credit on them.
7. Business conditions: credit expands in a boom and contracts in a slump.
8. Monetary policy of the central bank: bank rate, repo rate, open market operations and selective controls set the limits within which banks work.

6. Criticisms of the theory

• Edwin Cannan and Walter Leaf argued that banks do not create credit; they only lend what depositors have given them, as a cloakroom returns what is deposited. The answer is that, for the system as a whole, deposits are mostly the result of loans.
• The assumptions (no leakage, no excess reserves, constant demand for loans) are unrealistic, so the actual multiplier is much lower than 1/r.
• Banks cannot create credit at will: they depend on the cash base supplied by the central bank and on borrowers’ demand.
• Credit creation is not creation out of nothing: each derivative deposit is matched by a loan that must be repaid, so it is a creation of money, not of wealth.

How this is examined

For six marks: meaning, primary and derivative deposits, the four-row table and the formula 1/r, and three or four limitations. For ten marks, add the assumptions, the cash-leakage case, the single-bank point and the criticisms. Always state the reserve ratio you assume and check that deposits = reserves + loans in the total row (10,000 = 1,000 + 9,000).