Credit creation is one of the important functions of a commercial bank.
“A commercial bank is one that accepts deposits and lend loans and earns an income with the difference.”
Commercial banks expand the money supply in the economy through the form of credit creation. The banking structure is based on credit. Credit basically means getting the purchasing power now and promising to pay at some time in the future. Bank credit means bank loans and advances. Banks generally accept deposits but do not give the whole as loans. The banks keep a minimum reserve of the deposits for the demand of depositors and provides the remaining as loans. The deposits are generally ‘demand deposits’ which can be repayable on demand.
When providing a loan, the bank does not provide it as cash but opens a secondary depository account in the name of the borrower. Now, let us see what is primary and secondary deposits.
Primary deposits are deposits from a customer to a bank which forms the basis of credit. Secondary deposits are loans provided by bank to the borrower. The bank opens an account in the name of the borrower. In credit creation, every loan transaction happens only by opening a secondary depository account.
Let us understand the process of credit creation through the table below
The table above explains the process of credit creation by a single bank. In the table, the cash reserves are kept so that the bank can meet depositor’s needs and lends the rest of the deposits. In this bank, the cash reserves are kept at 20% of the total deposits. Now, a person A deposits an amount say Rs.1000. Person A’s deposits are the initial primary deposits. Of this 20%, that is, Rs.200 is taken for cash reserves and the remaining Rs.800 is taken for lending. Another person, say person B borrows an amount of Rs.800. This money is neither given in form of cash nor straightly to his bank account. The money is given in the form of secondary deposits. This marks the Round 1 of credit creation. Since the money is given in secondary deposits, for the bank, it considers it to be a new deposit because cash at bank increases by Rs800 and by charging 20% cash reserves and give the remaining amount of Rs.640 to lending to say, person C. This process continues for several rounds until the deposits become zero. At the end of the process, the bank has managed to multiply the amount of money supply which is circulating in the economy. As of the above example, the initial deposit amount was Rs.1000 but in the end, through the Multiplier Effect the money created is Rs.5000. Multiplier Effect refers to the ability of the bank to increase money supply through the process of borrowing and lending.
MULTIPLIER EFFECT = 1/CRR = 1/20% = 5 times
where CRR is the Cash Reserve Ratio
We can see observe from the table that the deposits have been multiplied by 5 times by the bank.