How do the banks create credit? What are the limitations on the power of banks create credit?

Credit creation is one of the important functions of commercial bank credit creation is the multiple expansion of the banks demand deposits. It is clear that bank advance a major portion of their deposits to the borrowers and keep a smaller portion of their funds to meet withdrawals. Even than the customers of the banks have full confidence that their deposits lying in the bank are quit safe and can be withdrawn on demand.

The bank explodes their trust of their customers and expends loans by much more than the amount of cash possessed by them. This process on the part of the banks to lend more than the amount of cash possessed by them is called as “creation of credit”.

For the purpose of credit creation the main parts of creation are “deposits”, so “limitation”.

Infact bank deposits are of two types.

1.                 Direct/primary deposits:

They consist of the money deposited with the banks by its customers in form of cash.

2.                 Indirect/creative deposits:

They are the deposits which creative by a banks in the process of lending of “financial activities”. It is only with respect to the creative deposits. We say that banks create credit:

                                    Expansion of deposits = organization x 1/cash reserve

                                                “Limitation of credit creation”

a.                 Cash reserve ratio:

A banker cannot lend up his all funds. It is essential for him to keep a reasonable portion of his funds as a cash reserve to meet the claques of their customers. If the central bank of the country fixes higher ratio of cash reserve, the power of commercial banks to create credit will be lower and vice versa.

b.                 Monitory policy:

The central bank has the power to effect the volume of credit expansion so contraction in the country. The use of different of credit control by the center bank has direct effect on the power of the banks to create or contract credit.

c.                  Cash drain:

Means the circulation of money/cash instead of cheques and bills. 

d.                 Availability of cash:

Credit creation also depends on the actual cash possessed by the bank. The larger amount of credit that can be creating by banks depends on the primary deposits.

e.                 Availability of collateral security:

Credit creation also depends on the availability of collateral security. If proper security is not available with customer, credit creation is not possible.