Credit Creation in commercial banks

Credit creation of commercial banks

The commercial banks are the second most important sources of money supply. The money that commercial banks supply is called credit money. The process of Credit Creation begins with banks lending

money out of primary deposits. Primary deposits are those

deposits which are deposited in banks. After maintaining the required reserves, the bank can lend the remaining portion of primary deposits. Here banks lend the money and the process of credit creation starts.

Process of Credit Creation.

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% which is decided by the RBIs 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 for the loan amount. At
the end of the process of deposits & lending, the balance sheet of bank read

S.No

Liabilities

Amount

Assets

Amount

01
Bank 1

A deposits

100.00

Cash Reserve

5.00

Loan to B

95.00

S.No

Liabilities

Amount

Assets

Amount

01
Bank 2

B deposits

95.00

Cash Reserve

4.75

Loan to C

90.25

Bank

Liabilities Assets

Reserves

Total Asset

Bank 1

100.00

95.00

5.00

100.00

Bank 2
Bank 3

95.00
90.25

90.25
85.73

4.75
4.52

95.00
90.25

The process will continue until the reserve with the banks is reduced to Zero Total 2000 1900.00 100.00 2000.00

Deposit multiplier.
The total deposit created by the commercial banks constitutes the money supply by the banks. Credit creation of commercial banks depends upon deposit multiplier.

Deposit multiplier = 1/r-where r is CRR, (5%) or 1/0.05 or 20 In the example primary deposit is Rs. 100/- Deposit multiplier is 20. Hence total credit creation of commercial banks equal to 100 x 20 = 2,000.

If depositors or borrowers choose to hold their money in cash instead of depositing, this slows down the money creation process. What percentage of deposits and bank loans do depositors and borrowers want to hold as cash instead of holding them in their accounts? We assumed 0%. In reality, this is positive.
7

Money multiplier in reality is smaller than 1/r. For example, while r is around 10% on average in a country, money multiplier may be around 7, not 10. The deposit multiplier or Money Multiplier can be reduced by increasing the CRR. If CRR is 10%,the money multiplier may be 10.(1/0.10)

The chain of multiple deposit creation

The RBI employs four measures of money stock, namely M1, M2, M3 and M4.

M1: This is the money supply ie the currency with the public
and demand deposits with the bank and other deposits with RBI.

In developed countries demand deposits form a major part of the money supply.

Demand deposits are primarily savings and current

account deposits where your are able to "demand" your money at any time, unlike a term deposit, which cannot be ordinarily accessed for a predetermined period.

M2: M1+Post Office Savings

M3 or aggregate money supply: M2 + Time Deposits

with the banks.

M4: M3+total Post office deposits other than NSC