Do banks create credit?

 

Do banks create credit?

 

how do banks create credit?

The creation of credit or deposits is one of the most important functions of commercial banks. Like other corporations, banks aim at earning profits. For this purpose, they accept cash in demand deposits and advance loans on credit to customers, When a bank advance a loan, it does not pay the amount of cash. But it opens a current account in his name and allows him to withdraw the required sum by cheque. In this way, the bank creates credit or deposits.

Demand deposits arise in two ways:

1.      When customers deposits currency with commercial banks and

2.      When banks advance loans, discount bills, provide overdraft facilities, and make investment through bonds advance loans.

The first type of demand deposits is called “primary deposit”. Banks play a passive role in opening them. The second type of demand deposits is called “derivative deposits”. Bank activity creates such deposit.

 

Do banks really create credit or deposit?

 

There have been two views on this subject: one held by certain economists like Hartley withers and the other held by practical bankers like Walter leaf.

According to withers, banks can create credit by opening deposit, every time they advance a loan. This is because every time a loan is sanction, payment is made through cheque by the customer. All such payments are adjusted through the clearing house. So long as loan is due, a deposit. Of that amount remains outstanding in the books of the bank, thus every loan creates a deposit. But this is an exaggerated and extreme view.

Dr Leaf and practical bankers do agree with this view. They go to the opposite extreme. They hold that banks cannot and do not create credit money.

This view is also wrong because it is based on argument relating to single bank. As pointed out by professor Samuelsson “ the banking system as a whole can do what each small bank cannot do: it can expand its loans and investments many times the new reserves of cash created for it, even though each small bank is lending out only a fraction of its deposits”

 

In fact, a bank is not a cloak room where one can keep currency notes and claim those very notes when one desires. Banks know by experience that all depositors do not withdraw their money simultaneously. Some withdraw while others deposits on the same day. So by keeping small cash in reserve for day to day transactions, the bank is able to advance loans on the basis of excess reserve. When the bank advances a loan it opens an account in the name of the customer. The bank knows by knows by experience that the customer will withdraw money by cheques which will be deposited by his creditors in this bank or some other bank, where they have their accounts. Settlement of all such cheques is made in the clearing house. The same procedure is followed in other banks. The banks are able to create credit or deposits by keeping small cash in reserve and lending the remaining amount of money.

In granting a loan, a bank actively creates a claim against itself in favor of the borrower. “The claims the bank takes from its customer, in exchange for the deposits entered in the books, are the bank’s assets. The standard assets of a commercial bank are overdraft and loans, bills, discounted, investment and cash.

The bank provides overdraft facilities to customer on the basis of some security. It enters the amount of the overdraft in the existing account of the customer and allows him to draw cheques for the overdraft amount agreed upon. It thus creates a deposit.

When a bank discounts a bill of exchange, it in fact, buys the bill from the customer for a short period of 90 days or less. The amount of bill is credited in the account of the customer who withdraws it through a cheque. Or, it pays the sum through a cheque on itself. In both cases, the bank creates a deposit equal to the amount of the bill of exchange less the discount charges.

A commercial bank also creates a deposit by making investment by purchasing government bonds through a cheque on itself to the central bank. If it buys a bond from the stock exchange, it credits the amount in the account of the seller, if he happens to be its customer. Otherwise, it pays a cheque on itself which is deposited in some other bank. In any case, a deposit is created either in this bank or some other bank. In all such cases, liabilities and assets in the banking system on the whole are increased. Thus loans by banks create deposits. It is in this sense that credit is created by commercial banks.

 

The process of credit creation:

 

Let us look at the actual process of credit creation. We have seen above that the ability of banks to create credit depends on the fact that banks need only asmall percentage of cash to deposits. If banks kept 100 percent cash against deposit, there would be no credit creation. Modern banks do not keep 100 percent cash reserve. They are legally required to keep a fixed percentage of their deposits in cash, say 10, 15 or 15 or 20 percent. They lend and or invest the remaining amount which is called excess reserve. A bank can lend equal to its excess reserve.

But the entire banking system can lend and create credit or deposits upon a multiple of its original excess reserve. The deposit multiplier depends upon the required reserve which is the basis of credit creation. Symbolically, the required reserve ratio:

 

RR = RR/D or RR = RRr × D

Where RR is the required cash reserve with banks, RRr is the required reserve ratio and D is the demand deposits of banks. To show that D depends on RR and RRr, divide both sides of the above equation by RRr:

RR/RRr = RRr × D/ RRr.

Where 1/RRr, the reciprocal of the percentage reserve ratio, is called the deposit for credit expansion multiplier. It determines the limits of the deposit expansion of a bank. The maximum amount of demand deposits which the banking system can support with any given amount of RR is by applying the multiplier to RR, Taking the initial change in the volume of deposits and in cash reserve. This is the extent to which the banking system can create credit.

The deposit expansion multiplier rests on the assumptions that banks lend out all their excess reserve and RRr remains constant. To explain the process of credit creation, we make the following assumptions:

1.      There are many banks, say A, B, C etc. in the banking system

2.      Each bank has to keep 10 percent of it deposits in reserve in other words, 10 percent is the required reserve ratio fixed by the monetary authorities which is the central bank of the country.

3.      The first bank has Rs 1000 as deposits

4.      The loan amount drawn by the customer of one bank is deposited in full in the second bank, and that of the second bank into the third bank, and so on.

5.      Each bank starts with the initial deposit which is deposited by the debtor of the other bank.

Given these assumptions suppose that bank A receives cash deposits of 1000 to begin with. This is the cash in hand with the bank which is its assets and this amount is also the liability of the bank by way of deposit it holds. Given the reserve ratio of 10 percent, the bank keeps 100 in reserve and lends 900 to one of its customers who, in turn, gives a cheque to some person from whom he borrows or buy something. The net changes in bank A is balance sheet are 100 in reserve and 900 in loans on the assets side and 1000 in demand deposit and the liabilities

 Side, Thus before this changes bank A had zero excess reserves.

 

 

 

Limitation on the power of banks to create credit: