Credit Creation

The process of 'Credit Creation' begins with banks lending money out of primary
deposits. Primary deposits are those deposits which are deposited in banks. In fact
banks cannot lend the entire primary deposits as they are required to maintain a certain
proportion of primary deposits in the form of reserves with the RBI under RBI & Banking
Regulation Act. After maintaining the required reserves, the bank can lend the remaining
portion of primary deposits. Here bank's lend the money and the process of credit
creation starts.
Suppose there are a number of Commercial Banks in the Banking System Bank 1,
Bank 2, Bank 3, & So on.
To begin with let us suppose that an individual "A" makes a deposit of Rs. 100 in bank 1.
Bank "1" is required to maintain a Cash Reserve Requirement of 5% (Prevailing Rate)
which is decided by the RBI's Monetary Policy from the deposits made by 'A'. Bank "1" is
required to maintain a cash reserve of Rs. 5 (5% of 100). The bank has now lendable
funds of Rs. 95(100 5). Let the Bank "1" lend Rs. 95 to a borrower; say B. the method
of lending is the same that is bank 1 opens an account in the name of the borrower
cheque for the loan amount. At the end of the process of deposits & lending, the balance
sheet of bank reads as given below:Balance Sheet of Bank "1"
Liabilities

Amount

Assets

Amount

A's deposits

100

Cash Reserve

Loan to "B"

95

Total

100

Total

100

Now suppose that money that borrowed from bank "1" is paid to individual "C" in
settlement of his past debts. The individual "C" deposits the money in his bank say, bank
2. Now bank 2 carries out its banking transaction. It keeps a cash reserve to the extent
of 5%, that is Rs. 4.75 (5% of 95) and lend Rs. 90.5 to a borrower D. at the end of the
process the balance sheet of Bank 2 will be look like:Balance Sheet of Bank "2"
Liabilities

Amount

Assets

Amount

B's deposits

95

Cash Reserve

4.75

Loan to "C"

90.5

Total

95

Total

95

The amount advanced to D will return ultimately to the banking system, as described in
case of B and the process of deposits and credit creation will continue until the reserve
with the banks is reduced to zero. The final picture that would emerge at the end of the
process of deposit & credit creation by the banking system is presented in the
consolidated balance sheet of all banks are as under:The combined Balance sheet of Banks
Bank

Liabilities

Assets Credits

Reserve

Total Assets

Deposits
Bank 1

100

95

100

Bank 2

95

90.5

4.75

95

Bank 3

90.5

85.98

4.52

90.5

Bank n

00

00

00

00

Total

2,000

1,900

100

2,000

It can be seen from the combined balance sheet that a primary deposits of Rs. 100 in a
bank 1 leads to the creation of the total deposit of Rs. 2,000. The combined balance
sheet also shows that the banks have created a total credit of Rs. 2,000. And maintained
a total cash reserve of Rs.100.Which equals the primary deposits. The total deposit
created by the commercial banks constitutes the money supply by the banks.