CreditCreation:Howdoes

CommercialBanksCreateCredit?
bySupriyaGuruCommercialBanks

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Creationofcreditisoneofthemostoutstandingfunctionsofa
modernbank.Abankhassometimesbeencalledafactoryforthe
manufactureofcredit.Howcreditiscreated?Itisanopensecret
thatthebanksdonotkeepcentpercentreservesagainstdepositsin
ordertomeetthedemandsofdepositors.
Thebankisnotacloakroomwhereyoucankeepyourcurrency
notesorcoinsandclaimthoseverynotesorcoinsbackwhenyou
desire.Itisgenerallyunderstoodthatmoneyreceivedbythebankis
meanttobeadvancedtoothers.
Adepositorhastobecontentsimplywiththebankspromiseor
undertakingtopayhimwheneverhemakesademand.Thusthe
banksareabletodowithaverysmallreserve,becauseallthe
depositorsdonotcometowithdrawmoneysimultaneouslysome
withdraw,whileothersdepositatthesametime.
Thebankisthusenabledtoerectavastsuperstructureofcrediton
thebasisofasmallcashreserve.Thebankisabletolendmoneyand
chargeinterestwithoutpartingwithcash,asthebankloancreates
simplyadepositoritcreatesacreditfortheborrower.Thisiswhat
ismeantbycreationofcredit.
Similarly,thebankbuyssecuritiesandpaysthesellerwithitsown
chequewhichagainisnocashitisjustapromisetopaycash.The

chequeisdepositedinsomebankandadepositiscreatedorcreditis
createdforthesellerofthesecurities.Thisiscreditcreation.
Thetermcreditcreationimpliesasituation,touseBenhams
words,whenabankmayreceiveinterestsimplybypermittinga
customertooverdrawtheiraccountsorbypurchasingsecuritiesand
payingforthemwithitsowncheques,thusincreasingthetotalbank
deposits.
Letusseetheactualprocess.Letusassumethatthereisonlyone
bankinthecountry.SupposeacustomerdepositsRs.1,000inthe
bank.Thebankhastopayhiminterest.Therefore,thebankmust
seekasafeandprofitableinvestmentforthisamount.Itmustlendit
tosomebody.Butthisamountisnotactuallypaidouttothe
borroweritisretainedbythebanktomeetitsobligations,i.e.,to
paytothoseofitsdepositorswhoneedcashanddrawchequesfor
thepurpose.
Thebanksexperiencetellshimthatforthispurposeonlyacertain
percentageofcashreservestototalliabilitiesneedbekept.In
countrieslikeEngland,theykeepnearly10percent.Theratioof
cashreservestoliabilitiesismuchhigherincountrieslikeIndia,
wherebankinghabithasyettodevelop.
Supposethebank,inwhichadepositorhasdepositedRs.1,000,
keeps20percentcashreservetomeetthedemandofdepositors.
Thismeansthat,assoonasthebankhasreceived1,000itwillmake
upitsmindtoadvanceloansuptotheamountofRs.5,000(only
onefifthreserveiskept).When,therefore,abusinessmancomesto
thebankwitharequestforaloanofRs.5,000,hemaybesureof
beinggrantedaccommodationtothisextent,providedofcourse,his
creditisgood.ThebanklendsRs.5,000,althoughithasonlyRs.
1,000incash.Itisherethatcreditcomesin.

Thistransactionisrenderedpossiblebecausetheborrowerisnot
giventheloanincashonlyanaccountisopenedinhisnameandthe
amountiscreditedtohisaccount.Heissimplygiventhecheque
book,i.e.,therighttodrawchequesasandwhenheneedsmoney.
Evenwhenhewithdrawscash,itwillbedepositedinthebankbythe
recipients,becausebusinessmendonotraisefundstokeepthem
lockedupinacashboxbuttoruntheirbusinessandtomake
paymentstotheircreditors.
Whenthisparticularbusinessmandrawschequesonthisbankto
payhiscreditors,thesechequesarepassedonbythemtotheirown
banks,wheretheamountisdepositedintheiraccount.Cashis
seldomwithdrawn.Thebanksadjusttheirmutualobligations
throughasystemofbankclearing.Thusthebankhassucceededin
creatingacreditofRs.5,000againstacashreserveofRs.1,000.
Thebankalsocreatescreditwhenitpurchasessecurities.Thebank
canpurchasesecuritieswithoutpayinganycash.Itissuesitsown
chequetopaythepurchaseprice.Thechequeisdepositedinthis
bankorsomeotherbankandthesmallcashreservewhichthebank
keepsissufficienttomeetanobligationarisingfromthistransaction
too.Itisthusthat,onasmallcashfoundation,avastsuperstructure
ofcreditisbuiltup.
Letusnowunderstandtheprocessofcreditcreationwhenthereare
severalbanksinthecountry,astheyareintherealworld.Inthecase
ofseveralcommercialbanksinthecountry,oneindividualbank
cannotcreateallthecreditasdescribedabove.Butwhatnosingle
bankcandoindividually,thebankingsystemasawholecando,i.e.,
createcredit.
Weshallexplaintheprocessofcreditcreationortheexpansionof
moneysupplyinthecountrybythebankingsystemcollectivelywith

thehelpofbalancesheetsofthebanks.Weshallillustratehow
depositofRs.1,00,000ofcurrencyinacommercialbankenables
thebankingsystemasawholetoexpanddepositsbyanotherRs.
4,00,000,thatis,depositsofRs.1,00,000incurrencyleadstoa
totaldepositsofRs.5,00,000inthebankingsystem.
Banks,asotherbusinessfirms,showtheirfinancialconditionona
balancesheet.Asimplebalancesheethastwocolumns,itsleft
columnrepresentsalltheassetsofabankanditsrightcolumn
representsalltheliabilitiesofabank.Assetsareallthethingsor
claimsabankowns,liabilities,ontheotherhand,areclaimsagainst
thoseassetssomeoftheclaimsareofcreditorsandsomeofthem
areofownersofthebanksthemselves.Becauseassetsshow
everythingthatabankownsandbecauseliabilitiesrepresentclaims
againstthoseassets,thetwosidesofthebalancesheet,thatis,assets
andliabilitiesmustequaleachother.
LetussupposethatanindividualorafirmdepositsRs.1,00,000in
cashwithabankA.Ignoringeverythingelseinthebalancesheet,let
usknowhowthebalancesheetofbankAwilllooklikewiththis
freshdepositofRs.1,00,000incurrencywithit.ThecashofRs.
1,00,000whichthebankAwillreceivewillbecomeitsassets,andat
thesametimeindividualsdepositsofRs.1,00,000willbeits
liabilities,theassetsandliabilitiesofbankAwillthereforebeequal
toeachother.
BANKA:
BalanceSheet

Letusassumethatcashreserveratiois20%.Nowthebankdoesnot

requirealltheRs.1,00,000incashagainstthedepositsofRs.1,
00,000.ThebankArequiresonly20%ofit,thatis.Rs.20.000cash
againstitsdepositsofRs.1,00,000.Thebankcanlendorinvestin
securitiestheremainingamountofRs.80,000.Actuallyifthebank
doesnotlendorinvestitwillsufferaloss,sinceitwillpaythe
interesttothedepositorwithnoprofitfromthecashitpossesses.
Therefore,thebankAwilllendRs.80,000tothebusinessfirmsor
individualswhomitfindscreditworthy.Now,whenabanklendstoa
personorfirmitdoesnotgivehimcashimmediately.Thebank
makesdepositsinthenameofthepersonwhomhelendsthemoney
andgiveshimtherighttodrawchequesagainstitwhenrequired.It
isanewdeposit,onethatdidnotexistbefore.
Thepersonorfirmgettingloansfromthebankwill,however,after
sometimecompletelywithdrawthemoneythroughchequesfrom
hisdeposits.
WhentheloanofRs.80,000hasbeensanctionedtoa
person,butbeforethatpersonstartswithdrawinghis
money,thebalancesheetofbankAwilllooklikeas
follows:
BANKA
BalanceSheet
(WhenthebanksanctionsloanofRs.80,000butbeforeloanis
cashed)

Inthisbalancesheet,loanofRs.80,000becomesassetofthebank,
whilethenewdepositscreatedconstitutetheliabilityofthebank,
sincethepersongettingtheloanhastherighttodrawuponthese
deposits.Now,whenthepersonwhollywithdrawshisdeposits
throughchequesandtherecipientsofthesechequesdepositthemin
someotherbank,saybankB,thenthebankAwillhavetosurrender
tobankBcashmoneyequaltoRs.80,000.
AfterthewholenewlycreateddepositsofRs.80,000have
beenthuswithdrawn,thebalancesheetofbankAwillnow
looklikeasfollows:
BANKA
BalanceSheet

Assaidabove,chequesworthRs.80,000againstBankAare
depositedinBankB,fortheBankBthesewillconstitutenewcash
moneyandwillthereforebecometheassetsofbankB.ButRs.
80.000willalsobetheliabilityofthebankBintheformofdeposits
inthenameofthosepersonswhohavedepositedthechequeswith
it.
IgnoringotherassetsandliabilitiesofbankBandtaking
intoaccountonlythisabovetransaction,thebalancesheet
ofbankBwillbeasfollows:
BANKB

NowagainstthedepositsofRs.80,000bankBrequirestokeepits
20%,thatis,Rs.16,000anditcanlendorinvesttheremaining
amountofRs.64.000.
WhenbankBlendsRs.64,000toafirm,itwillcreate
depositsforthatfirm.Beforethefirmdrawsuponthose
deposits,thebalancesheetofbankBwilltooklike:
BANKB
BalanceSheet

Now,whenthefirmwhichhasgotloanfrombankBcompletely
withdrawsRs.64,000throughcheques,thebalancesheetofbankB
willbeasfollows.Asaresultofthefirmspendingtheloanmoneyof
Rs.64,000,thebankBwilltransfercashofRs.64,000toanother
bank,sayC,inwhichthechequesdrawnbythefirmaredeposited.
Asaresultofthis,thecashwithbankBwillfalltoRs.16,000(Rs.
80,000Rs.64,000=Rs.16,000).
BANKB
BalanceSheet

NowwhenthebankCwillgetRs.64,000,itwillalsorequiretokeep
20%ofit(i.e.,Rs.12,800)andtheremainingamountofRs.51,200
willbelentoutorinvestedbyit.Fromtheforegoinganalysisitis
clearthatthecurrencydepositsofRs.1,00,000ledtothecreation
ofdepositsofRs.80,000byBankA,Rs.64,000byBankB,andRs.
51,200byBankC.Buttheprocessofexpansionofdepositswillnot
stophere,itwillgoonasthemoneylentoutbyonebankisspent
throughchequesandthesechequesaredepositedinotherbanks,till
thetotaldepositsofRs.5,00,000inallthebanks(includingoriginal
depositsofRs.1,00,000)arecreated.
Butitshouldberememberedthatateachstagethenewdeposits
createdbyabankgoesondeclining.Thisisbecauseateachstagea
bankisrequiredtokeep20%ofthemoneyitreceivesascash
reservesandthereforelendsandcreatesdepositsequalonlytothe
remainingamount.ThusbankAcreateddepositsofRs.80,000,
bankBcreateddepositsofRs.64,000,bankCcreateddepositsof
Rs.51,200andsoon.
Wearenowinapositiontostatehowmuchdepositshavebeen
createdbythebankingsystemoutofthecurrencydepositsofRs.1,
00,000.
TotalDeposits=Rs.1,00,000+80,000+64,000+51,200+=
Rs.5,00,000OutofthetotaldepositsofRs.5,00,000,thedeposits
ofRs.1,00,000incashwasmadeinthebankingsystem,the
remainingdepositshavebeencreatedbythebankingsystemitself,
asifoutofthinair.

Depositscreatedbythe=Rs.5,00,0001,00,000
bankingsystem=Rs.4,00,000
Itshouldbefurthernotedthatthetotalexpansionofdepositsbythe
bankingsystemdependsuponthecashreserveratio(CRR).The
smallerthecashreserveratiothelargetheexpansionofdepositsor
credit.Thus,intheabovecase,wenotedthat,giventhecashreserve
ratioof20%,thetotaldepositsexpansionfromthecashdepositsof
Rs.1,00,000,wasequaltoRs.5,00,000.Thusthetotaldeposits
expandedtowasfivetimestheoriginalcashdeposits.
Thereforethedepositofcashinthebankingsystemleadstomultiple
expansionsinthetotaldeposits.Thisisknownasdepositsorcredit
multiplier.Inourabovecase,thedepositsorcreditmultiplieris5.It
shouldberememberedthatthemagnitudeofdepositsmultiplier
dependsonthecashreserveratio.
Depositmultiplierdm=1/r
whererstandsforcashreserveratio.
Thusdepositmultiplieristhereciprocalofcashreserveratio(CRR)
whichwehavedenotedbyrinthemeasureofdepositmultiplier.
Thus,whenthecashreserveratiois20%,thatis,0.20or1/5,the
depositmultiplier.
=1/1/5=5
Now,ifthecashreserveratioisraisedbyReserveBankto25per
cent,thatis,0.25,thedepositmultiplier,
dm=1/0.25=1/1/4=4

Thus,thegreaterthecashreserveratio,thelowerwillbethevalueof
depositmultiplier.Inotherwords,increaseinthecashreserveratio
(CRRorr)willleadtothecontractionofcreditcreatedbythebanks,
andviceversa.

Similarly,ifthecashreserveratiois10%,i.e.,1/10,thenthedeposits
multiplier=1/1/10=10.Inthiscaseinitialdepositsofsomecash
amountinthebankingsystemwillleadtotentimesexpansioninthe
totaldeposits.Figure11.1makescleartheprocessofdeposits
expansionbythebankingsystem.
DepositMultiplierandCreditMultiplier:
Someeconomistsdistinguishbetweendepositmultiplierandcredit
multiplier.Inouraboveexample,originalorprimarydepositsofRs.
100,000madebythepublicinthebankingsystem,giventhecash
reserveratio(r)equalto20percenti.e.0.20),resultedinthe
increaseintotaldepositsinthebankingsystemequaltoRs.
500,000.IfwedenotetotalincreaseindepositsbyADandoriginal
increaseincashdepositsasAR,thenthedepositmultipliercanbe
writtenas

dm=D/R
or,inourfirstexample,dm=D/R=1/r=1/0.20=5
Now,inouraboveexampletheprimarycashdepositsofRs.100,000
ledtothecreationofdeposits(i.e.increaseincredit)equaltoRs.4,
00,000bythebankingsystemitselfwhenmakingloansorcreating
creditforbusinessmen.
Thecreditmultipliermeasurestheextentbywhichthebanking
systemcreatescreditasaresultofnewincreaseinprimarydeposits
whichtheyuseasreserves.Ifwedenotecreditcreatedbythebanks
asACandtheincreaseinprimarydepositsascashwiththebanksas
AR,thencreditmultipliercanbewrittenas
Cm=C/R
WhereCmrepresentscreditmultiplier
Since
C=DR
Cm=DR/R=D/RR/R=D/R1
D/R=dm
Therefore,
Cm=dm1
=1/r1
=1r/r

LimitationsontheCreditCreatingPoweroftheBanks:
Fromtheforegoingaccountofcreditordepositscreationbythe
banks,itwouldseemthatthebanksreapwheretheyhavenotsown.
Theyadvanceloansorbuysecuritieswithoutactuallypayingcash.
Buttheyearninterestontheloanstheygiveorearndividendsonthe
securitiestheypurchaseallthesame.
Thisisverytempting.Theymakeprofitswithoutinvestingcash.
Theywould,ofcourse,liketomakeasmuchprofitlikethisasthey
can.Buttheycannotgoonexpandingcreditindefinitely.Intheir
owninterest,theyhavetoapplythebrake,andtheydoactually
applyit,foritiswellknownthattheprofitsmadebythebanksare
notveryhigh.Theoverridinglimitationarisesfromtheobligationof
thebankstomeetthedemandsoftheirdepositors.
Benhamhasmentionedthreelimitationsonthepowersof
thebankstocreatecredit:
(i)Theamountofcashinthecountry
(ii)Theamountofcashwhichthepublicwishestoholdand
(iii)Theminimumpercentageofcashtodeposits,calledcash
revenueratiowhichthebankshavetomaintain.
(iv)Theamountofmoneywhichthepublicwantstoholdasdeposits
inthebanks.
Asfor(i),itmaybesaidthatcreditcanbecreatedonthebasisof
cash.Thelargerthecash(i.e.,legaltendermoney)thelargerthe
amountofcreditthatcanbecreated.Buttheamountofcashthata
bankmayhaveissubjecttothecontrolofthecentralbank.The
centralbankhasthemonopolyofissueofcash.Itmayincreaseitor

decreaseit,andcreditwillexpandorcontractaccordingly.The
powerofthecentralbanktocontrolcurrencyhelpsittocontrolthe
extentofcreditthatthebankshavethepowertocreate.
Thesecondlimitationarisesfromthehabitofthepeopleregarding
theuseofcashi.e.currency.Ifpeopleareinthehabitofusingcash
andnotcheques,asinIndia,thenassoonascreditisgrantedbythe
banktoaborrower,hewilldrawthechequeandgetcash.Whenthe
bankscashreservesarethusreduced,itspowertocreatecreditis
correspondinglyreduced.
Ontheotherhand.Ifpeopleusecashonlyforverysmallandodd
transactions,thenthecashreserveofthebanksisnotmuchdrawn
uponandtheirpowerofcreatingcreditremainsun
impaired.Thisis
thecaseinadvancedcountriesliketheU.S.A.,Englandandother
Europeancountries.Therethebankshardlykeep10percentcash
reserve.
Thethirdlimitationisthemostimportant.Itarisesfromthecash
reserveratiocash,whichthebanksmustmaintaintoensurethe
safetyofthebankandtoretainthedegreeofliquiditythatis
considereddesirable.Itisclearthatwhenabankcreatesacreditor
grantsaloan,itundertakesaliability.Thereisanincreaseinits
liabilitiesandthereiscorrespondinglyafallincashreserveratio.
Thebankwillnotletthecashreserveratiofallbelowacertain
minimum.
Whenthatminimumisreached,thepowerofthebanktocreate
creditcomestoanend.Tograntanyfurthercreditwillberisky
unlessthebanksexperienceisreassuringenoughtopermitthe
adoptionofalowerpercentage.Thenthatwouldbethelimit.
Theotherimportantlimitationonthecreditcreatingpowerofbanks

istheamountofmoneywhichthepublicchoosetoholdasdeposits
inbanks.Themoremoneywhichthepublicdepositswiththebanks,
themorereservesbankswouldhaveandthereforemorecreditthey
willbeabletocreateandviceversa.
Itmaynotedthatpubliccanusetheirsavedmoneyinmorethanone
way.Thepubliccanbuysharesordebentureofthecompanies,itcan
investinmutualfundsofbothpublicandprivatessectors.Butthe
creditcreationbythebanksdependsonthemoneythepublic
depositsinthem.Itisimportanttonotethanrateofinterestpaidby
thebanksondepositsdeterminestoagoodextenttheamountof
moneydepositswiththembythepublic.Otherthingsbeingequal,
thehighertherateofinterest,thegreatertheamountofmoneythe
publicwilldepositmoneywiththebanks.
Tothesemaybeaddedthefourthlimitation.Thebankcannotcreate
creditwithoutac
quiringsomeasset.Anassetisaformofwealth.
Thusthebankonlyturnsimmobilewealthintomobilewealth.
Hence,asCrowtherobserves,thebankdoesnotcreatemoneyout
ofthinair,ittransmutesotherformsofwealthintomoney.
However,bankingsystemtodayhasbecomequiteadvanced.These
daysbanksgivecreditonthebasisofpersonalgoodwillratherthan
onthebasisofanyformofwealth.
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