MEANING OF CREDIT CREATION:The commercial banks create multiple expansions of their bank deposits and due to this, these

are called the factories of credit. The banks advance a major portion of their, deposits to the
borrowers and keep a smaller part with them. The customers have full confidence on the bank.
The banks expand loans by much more than the amount of cash possessed by them. This
tendency on the part of the banks to lend more than the amount of cash possessed by them is
called Creation of credit in Economics.

BANKS CREATE CREDIT IN TWO WAYS :1. By over drafting.

2. By purchase of securities.
By over drafting bank creates credit. Secondly bank purchases the securities and pays them with
its own cheques. The holders of these cheques deposit them in the same banks. This creates
deposit which is nothing other than creation of credit.
According to Benhen : " A bank may receive interest simply by permitting a customer to
overdraw their account or by purchasing securities and having for them with its own cheques.
Thus increasing the total bank drafts. One should remember that single bank creates a very little
credit. It is a whole banking system which can expand the credit."
Secondly when loans is advanced, it is not given in cash. The bank opens a deposit account in
the name of the borrower and allows him draw to draw whenever required. The loan advanced by
cheques results in the creation of new demand deposits. Sometimes, a question arises that it
borrowers with draw these deposits for the repayment to other persons, then how the banks will
create credit. The answer is that other persons who receive money may also be the clients of the
bank. Naturally they will also deposit their cash in the bank. The process remains continue. We
can explain it by the following example .
Example :- Suppose a person deposits 1,000 in a bank. According to experience bank can keep
20% cash reserve to meet the demands of the depositors, and can lend the rest safely to the
borrowers. If all the bank maintain a reserve ratio of 20% then banks can succeed in creating a
credit a credit of Rs. 5000 against an original deposit of Rs. 1,000 in cash.

CONTRACTION OF CREDIT :The contraction of credit adversely affects the money supply. The contraction of bank credit may
take place due to many visions. For example the bank may recall loans or due to political
uncertainty or due to fall in price borrower may stop the borrowing.
According to Pritchard : " Contraction by any single bank in this system will place pressure on
other banks and if their excess reserve position is inadequate and the banks are unable to meet
their excess reserves through the agency of the central bank then a multiple process of credit
contraction will start."

LIMITATION OF CREDIT :Banks have not unlimited credit creation powers. There are so many restrictions which can be

discussed as under :
1. Restriction By The Central Bank :If the banks have large deposits they can create more credit and if they have small deposits then
their power of credit creation will be limited. While we know the commercial bank has the
monopoly of note issue, if the central bank increase the quantity of money the deposits of
commercial banks will increase and they will expand the volume of credit in the enquiry. On the
other hand if supply of money decreases, the volume of credit also of decreases. Any how the
credit creation power of the commercial bank is directly affected by the policy of the central
bank.
2. Habits Of The Customers :The power to create credit by the commercial banks is very much influenced by the habits of the
people living in that country. If the people are habitual in using the cheques then the volume of
credit will expand on the other it will be contracted.
3. The Cash Ratio :Every bank keeps an adequate cash reserves for meeting the cash requirements of its
customers. The bank will not allow its cash ratio to fall below a certain minimum level. When this
level is reached then bank will not advance money.
4. The Collateral Security Available :The bank advances loan to the borrowers against some kind of Collateral Security. If these are
not available then the power of credit creation will be restricted.
These were some limitations in the way of credit creation

CREATION OF CREDIT
Creation of credit is one of the most outstanding functions of a modern bank. A bank has sometimes been called
a factory for the manufacture of credit. How credit is created? It is an open secret that the banks do not keep
cent per cent reserves against deposits in order to meet the demands of depositors.
The bank is not a cloak room where you can keep your currency notes or coins and claim those very notes or
coins back when you desire. It is generally understood that money received by the bank is meant to be advanced
to others.
A depositor has to be content simply with the banks promise or undertaking to pay him whenever he makes a
demand. Thus the banks are able to do with a very small reserve, because all the depositors do not come to
withdraw money simultaneously; some withdraw, while others deposit at the same time.
The bank is thus enabled to erect a vast superstructure of credit on the basis of a small cash reserve. The bank is
able to lend money and charge interest without parting with cash, as the bank loan creates simply a deposit or it
creates a credit for the borrower. This is what is meant by creation of credit.
Similarly, the bank buys securities and pays the seller with its own cheque which again is no cash; it is just a
promise to pay cash. The cheque is deposited in some bank and a deposit is created or credit is created for the
seller of the securities. This is credit creation.

The term credit creation implies a situation, to use Benhams words, when a bank may receive interest simply
by permitting a customer to overdraw their accounts or by purchasing securities and paying for them with its
own cheques, thus increasing the total bank deposits.
Let us see the actual process. Let us assume that there is only one bank in the country. Suppose a customer
deposits Rs. 1,000 in the bank. The bank has to pay him interest. Therefore, the bank must seek a safe and
profitable investment for this amount. It must lend it to somebody. But this amount is not actually paid out to
the borrower; it is retained by the bank to meet its obligations, i.e., to pay to those of its depositors who need
cash and draw cheques for the purpose.
The banks experience tells him that for this purpose only a certain percentage of cash reserves to total liabilities
need be kept. In countries like England, they keep nearly 10 per cent. The ratio of cash reserves to liabilities is
much higher in countries like India, where banking habit has yet to develop.
Suppose the bank, in which a depositor has deposited Rs. 1,000, keeps 20 per cent cash reserve to meet the
demand of depositors. This means that, as soon as the bank has received 1,000 it will make up its mind to
advance loans up to the amount of Rs. 5,000 (only one-fifth reserve is kept). When, therefore, a businessman
comes to the bank with a request for a loan of Rs. 5,000, he may be sure of being granted accommodation to
this extent, provided of course, his credit is good. The bank lends Rs. 5,000, although it has only Rs. 1,000 in
cash. It is here that credit comes in.
This transaction is rendered possible because the borrower is not given the loan in cash; only an account is
opened in his name and the amount is credited to his account. He is simply given the cheque book, i.e., the right
to draw cheques as and when he needs money. Even when he withdraws cash, it will be deposited in the bank
by the recipients, because businessmen do not raise funds to keep them locked up in a cash box but to run their
business and to make payments to their creditors.
When this particular businessman draws cheques on this bank to pay his creditors, these cheques are passed on
by them to their own banks, where the amount is deposited in their account. Cash is seldom withdrawn. The
banks adjust their mutual obligations through a system of bank clearing. Thus the bank has succeeded in
creating a credit of Rs. 5,000 against a cash reserve of Rs. 1,000.
The bank also creates credit when it purchases securities. The bank can purchase securities without paying any
cash. It issues its own cheque to pay the purchase price. The cheque is deposited in this bank or some other bank
and the small cash reserve which the bank keeps is sufficient to meet an obligation arising from this transaction
too. It is thus that, on a small cash foundation, a vast superstructure of credit is built up.
Let us now understand the process of credit creation when there are several banks in the country, as they are in
the real world. In the case of several commercial banks in the country, one individual bank cannot create all the
credit as described above. But what no single bank can do individually, the banking system as a whole can do,
i.e., create credit.
We shall explain the process of credit creation or the expansion of money supply in the country by the banking
system collectively with the help of balance sheets of the banks. We shall illustrate how deposit of Rs. 1,00,000
of currency in a commercial bank enables the banking system as a whole to expand deposits by another Rs.
4,00,000, that is, deposits of Rs. 1,00,000 in currency leads to a total deposits of Rs. 5,00,000 in the banking
system.

Banks, as other business firms, show their financial condition on a balance sheet. A simple balance sheet has
two columns, its left column represents all the assets of a bank and its right column represents all the liabilities
of a bank. Assets are all the things or claims a bank owns, liabilities, on the other hand, are claims against those
assets; some of the claims are of creditors and some of them are of owners of the banks themselves. Because
assets show everything that a bank owns and because liabilities represent claims against those assets, the two
sides of the balance sheet, that is, assets and liabilities must equal each other.
Let us suppose that an individual or a firm deposits Rs. 1, 00,000 in cash with a bank A. Ignoring everything
else in the balance sheet, let us know how the balance sheet of bank A will look like with this fresh deposit of
Rs. 1, 00,000 in currency with it. The cash of Rs. 1,00,000 which the bank A will receive will become its assets,
and at the same time individuals deposits of Rs. 1,00,000 will be its liabilities, the assets and liabilities of bank
A will therefore be equal to each other.
BANK A:

Balance Sheet
Let us assume that cash reserve ratio is 20%. Now the bank does not require all the Rs. 1, 00,000 in cash against
the deposits of Rs. 1, 00,000. The bank A requires only 20% of it, that is. Rs. 20.000 cash against its deposits of
Rs. 1, 00,000. The bank can lend or invest in securities the remaining amount of Rs. 80,000. Actually if the bank
does not lend or invest it will suffer a loss, since it will pay the interest to the depositor with no profit from the
cash it possesses.
Therefore, the bank A will lend Rs. 80,000 to the business firms or individuals whom it finds creditworthy.
Now, when a bank lends to a person or firm it does not give him cash immediately. The bank makes deposits in
the name of the person whom he lends the money and gives him the right to draw cheques against it when
required. It is a new deposit, one that did not exist before.
The person or firm getting loans from the bank will, however, after some time completely withdraw the money
through cheques from his deposits.
When the loan of Rs. 80,000 has been sanctioned to a person, but before that person starts withdrawing
his money, the balance sheet of bank A will look like as follows:
BANK A
Balance Sheet
(When the bank sanctions loan of Rs. 80,000 but before loan is cashed)

In this balance sheet, loan of Rs. 80,000 becomes asset of the bank, while the new deposits created constitute
the liability of the bank, since the person getting the loan has the right to draw upon these deposits. Now, when
the person wholly withdraws his deposits through cheques and the recipients of these cheques deposit them in
some other bank, say bank B, then the bank A will have to surrender to bank B cash money equal to Rs. 80,000.
After the whole newly created deposits of Rs. 80,000 have been thus withdrawn, the balance sheet of bank
A will now look like as follows:
BANK A
Balance Sheet

As said above, cheques worth Rs. 80,000 against Bank A are deposited in Bank B, for the Bank B these will
constitute new cash money and will therefore become the assets of bank B. But Rs. 80.000 will also be the
liability of the bank B in the form of deposits in the name of those persons who have deposited the cheques with
it.
Ignoring other assets and liabilities of bank B and taking into account only this above transaction, the
balance sheet of bank B will be as follows:
BANK B

Now against the deposits of Rs. 80,000 bank B requires to keep its 20%, that is, Rs. 16,000 and it can lend or
invest the remaining amount of Rs. 64.000.
When bank B lends Rs. 64,000 to a firm, it will create deposits for that firm. Before the firm draws upon
those deposits, the balance sheet of bank B will took like:
BANK B
Balance Sheet

Now, when the firm which has got loan from bank B completely withdraws Rs. 64,000 through cheques, the
balance sheet of bank B will be as follows. As a result of the firm spending the loan money of Rs. 64,000, the
bank B will transfer cash of Rs. 64,000 to another bank, say C, in which the cheques drawn by the firm are
deposited. As a result of this, the cash with bank B will fall to Rs. 16,000 (Rs. 80,000 Rs. 64,000 = Rs.
16,000).
BANK B
Balance Sheet

Now when the bank C will get Rs. 64,000, it will also require to keep 20% of it (i.e., Rs. 12,800) and the
remaining amount of Rs. 51,200 will be lent out or invested by it. From the foregoing analysis it is clear that the
currency deposits of Rs. 1, 00,000 led to the creation of deposits of Rs. 80,000 by Bank A, Rs. 64,000 by Bank
B, and Rs. 51,200 by Bank C. But the process of expansion of deposits will not stop here, it will go on as the
money lent out by one bank is spent through cheques and these cheques are deposited in other banks, till the
total deposits of Rs. 5,00,000 in all the banks (including original deposits of Rs. 1,00,000) are created.
But it should be remembered that at each stage the new deposits created by a bank goes on declining. This is
because at each stage a bank is required to keep 20% of the money it receives as cash reserves and therefore
lends and creates deposits equal only to the remaining amount. Thus bank A created deposits of Rs. 80,000,
bank B created deposits of Rs. 64,000, bank C created deposits of Rs. 51,200 and so on.
We are now in a position to state how much deposits have been created by the banking system out of the
currency deposits of Rs. 1, 00,000.
Total Deposits = Rs. 1,00,000 + 80,000 + 64,000 + 51,200 + = Rs. 5,00,000 Out of the total deposits of Rs.
5,00,000, the deposits of Rs. 1,00,000 in cash was made in the banking system, the remaining deposits have
been created by the banking system itself, as if out of thin air.
Deposits created by the = Rs. 5, 00,000- 1, 00,000
banking system= Rs. 4,00,000
It should be further noted that the total expansion of deposits by the banking system depends upon the cash
reserve ratio (CRR). The smaller the cash reserve ratio the large the expansion of deposits or credit. Thus, in the
above case, we noted that, given the cash reserve ratio of 20%, the total deposits expansion from the cash
deposits of Rs. 1, 00,000, was equal to Rs. 5, 00,000. Thus the total deposits expanded to was five times the
original cash deposits.
Therefore the deposit of cash in the banking system leads to multiple expansions in the total deposits. This is
known as deposits or credit multiplier. In our above case, the deposits or credit multiplier is 5. It should be
remembered that the magnitude of deposits multiplier depends on the cash reserve ratio.

Deposit multiplier dm = 1/r

where r stands for cash reserve ratio.
Thus deposit multiplier is the reciprocal of cash reserve ratio (CRR) which we have denoted by r in the measure
of deposit multiplier.
Thus, when the cash reserve ratio is 20%, that is, 0.20 or 1/5, the deposit multiplier.
= 1/1/5 = 5
Now, if the cash reserve ratio is raised by Reserve Bank to 25 per cent, that is, 0.25, the deposit multiplier,
dm = 1/0.25 = 1/1/4 = 4
Thus, the greater the cash reserve ratio, the lower will be the value of deposit multiplier. In other words,
increase in the cash reserve ratio (CRR or r) will lead to the contraction of credit created by the banks, and vice
versa.

Similarly, if the cash reserve ratio is 10%, i.e., 1/10, then the deposits multiplier = 1/1/10 = 10. In this case
initial deposits of some cash amount in the banking system will lead to ten times expansion in the total deposits.
Figure 11.1 makes clear the process of deposits expansion by the banking system.
Deposit Multiplier and Credit Multiplier:
Some economists distinguish between deposit multiplier and credit multiplier. In our above example, original or
primary deposits of Rs. 100,000 made by the public in the banking system, given the cash reserve ratio (r) equal
to 20 per cent i.e. 0.20), resulted in the increase in total deposits in the banking system equal to Rs. 500,000. If
we denote total increase in deposits by AD and original increase in cash deposits as AR, then the deposit
multiplier can be written as
dm = D/ R

or, in our first example, dm = D/ R = 1/r = 1/0.20 = 5

Now, in our above example the primary cash deposits of Rs. 100,000 led to the creation of deposits (i.e. increase
in credit) equal to Rs. 4, 00,000 by the banking system itself when making loans or creating credit for
businessmen.
The credit multiplier measures the extent by which the banking system creates credit as a result of new increase
in primary deposits which they use as reserves. If we denote credit created by the banks as AC and the increase
in primary deposits as cash with the banks as AR, then credit multiplier can be written as
Cm = C/ R
Where Cm represents credit multiplier
Since
C = D R
Cm = D R/ R = D/R R/R = D/R 1
D/R = dm
Therefore,
Cm = dm-1
= 1/r 1
= 1-r/r
Limitations on the Credit Creating Power of the Banks:
From the foregoing account of credit or deposits creation by the banks, it would seem that the banks reap where
they have not sown. They advance loans or buy securities without actually paying cash. But they earn interest
on the loans they give or earn dividends on the securities they purchase all the same.
This is very tempting. They make profits without investing cash. They would, of course, like to make as much
profit like this as they can. But they cannot go on expanding credit indefinitely. In their own interest, they have
to apply the brake, and they do actually apply it, for it is well-known that the profits made by the banks are not
very high. The overriding limitation arises from the obligation of the banks to meet the demands of their
depositors.
Benham has mentioned three limitations on the powers of the banks to create credit:
(i) The amount of cash in the country;
(ii) The amount of cash which the public wishes to hold; and
(iii) The minimum percentage of cash to deposits, called cash revenue ratio which the banks have to maintain.

(iv) The amount of money which the public wants to hold as deposits in the banks.
As for (i), it may be said that credit can be created on the basis of cash. The larger the cash (i.e., legal tender
money) the larger the amount of credit that can be created. But the amount of cash that a bank may have is
subject to the control of the central bank. The central bank has the monopoly of issue of cash. It may increase it
or decrease it, and credit will expand or contract accordingly. The power of the central bank to control currency
helps it to control the extent of credit that the banks have the power to create.
The second limitation arises from the habit of the people regarding the use of cash i.e. currency. If people are in
the habit of using cash and not cheques, as in India, then as soon as credit is granted by the bank to a borrower,
he will draw the cheque and get cash. When the banks cash reserves are thus reduced, its power to create credit
is correspondingly reduced.
On the other hand. If people use cash only for very small and odd transactions, then the cash reserve of the
banks is not much drawn upon and their power of creating credit remains unimpaired. This is the case in
advanced countries like the U.S.A., England and other European countries. There the banks hardly keep 10 per
cent cash reserve.
The third limitation is the most important. It arises from the cash reserve ratio cash, which the banks must
maintain to ensure the safety of the bank and to retain the degree of liquidity that is considered desirable. It is
clear that when a bank creates a credit or grants a loan, it undertakes a liability. There is an increase in its
liabilities and there is correspondingly a fall in cash reserve ratio. The bank will not let the cash reserve ratio fall
below a certain minimum.
When that minimum is reached, the power of the bank to create credit comes to an end. To grant any further
credit will be risky unless the banks experience is reassuring enough to permit the adoption of a lower
percentage. Then that would be the limit.
The other important limitation on the credit creating power of banks is the amount of money which the public
choose to hold as deposits in banks. The more money which the public deposits with the banks, the more
reserves banks would have and therefore more credit they will be able to create and vice versa.
It may noted that public can use their saved money in more than one way. The public can buy shares or
debenture of the companies, it can invest in mutual funds of both public and privates sectors. But the credit
creation by the banks depends on the money the public deposits in them. It is important to note than rate of
interest paid by the banks on deposits determines to a good extent the amount of money deposits with them by
the public. Other things being equal, the higher the rate of interest, the greater the amount of money the public
will deposit money with the banks.
To these may be added the fourth limitation. The bank cannot create credit without acquiring some asset. An
asset is a form of wealth. Thus the bank only turns immobile wealth into mobile wealth. Hence, as Crowther
observes, the bank does not create money out of thin air, it transmutes other forms of wealth into money.
However, banking system today has become quite advanced. These days banks give credit on the basis of
personal goodwill rather than on the basis of any form of wealth.