How Do Commercial Banks Create Credit? Step-by-Step Explanation with Examples
Credit creation by commercial banks is a foundational concept in economics and banking. It refers to the process by which banks increase the money supply in an economy by lending out a fraction of the deposits they receive from customers. This lending process enables banks to create more demand deposits, making credit creation crucial for economic growth and day-to-day transactions.
Banks differ from other financial institutions because of their unique credit creation function. When a bank receives a deposit, it holds a required portion as reserves and lends out the rest. These loans often end up being deposited in other banks, repeating the cycle and expanding the total amount of deposits in the system. Thus, the primary deposits by customers lead to the creation of secondary or derivative deposits through lending activity.
The main purpose of a commercial bank is not only to keep customers’ money safe but also to grant loans and advances, aiming for profitability. Banks must carefully manage liquidity to honor customer withdrawal requests while using remaining funds to earn interest through lending. The assumption behind credit creation is that not all depositors demand cash at the same time, allowing the bank to safely lend a significant portion of its deposits.
Key Principles and Definitions
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Credit Creation:
The process by which banks expand their deposits and increase the money supply by lending out a part of the funds they receive as deposits.
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Primary Deposits:
Deposits accepted directly from customers in exchange for cash. These serve as the initial basis for further credit creation.
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Secondary (Derivative) Deposits:
Deposits created when banks issue loans. The loan is usually credited to the borrower’s account and can be spent or re-deposited, fueling further credit creation.
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Cash Reserve Ratio (CRR):
The fraction of total deposits that banks must keep as cash reserves with the central bank. A lower CRR increases banks’ lending capacity and vice versa.
Step-by-Step Credit Creation Process
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Deposit Acceptance:
A customer deposits ₹10,000 into Bank A.
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Reserve Maintenance:
If the CRR is 20%, Bank A keeps ₹2,000 as reserves with the central bank and can lend ₹8,000.
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Loan Creation:
Bank A lends ₹8,000. The borrower may deposit this with Bank B, which then holds a portion as reserve and re-lends the remainder.
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Deposit Expansion:
This process continues, gradually multiplying deposits and credit across the banking system, based on the reserve requirement.
Credit Creation Formula and Calculation
| Term | Formula | Explanation |
|---|---|---|
| Money Multiplier | 1 / Legal Reserve Ratio (LRR) | Determines how many times original deposit can generate total credit in the economy. |
| Total Credit Created | Initial Deposit × Money Multiplier | Gives the maximum potential credit creation based on the original deposit and reserve ratio. |
For example, if the CRR (or LRR) is 20% (0.20), then the money multiplier is 1/0.20 = 5. If ₹10,000 is initially deposited, total credit created will be ₹10,000 × 5 = ₹50,000. Each time the funds are re-lent and re-deposited, banks keep only a fraction as reserve, lending the rest, thus expanding credit multiple times over the original deposit.
Limitations of Credit Creation
- Mandatory reserves set by the central bank, such as CRR and SLR.
- Availability of cash and total initial deposits in the banking system.
- Public preference for holding cash instead of depositing it in banks.
- Central bank policies, controls, and regulations, including changes in CRR or interest rates.
- Presence of leakages (currency or cash drain outside the banking system).
- General business environment and credit demand in the economy.
Comparison Table: Credit Creation and Its Limitations
| Feature | Credit Creation | Limitation |
|---|---|---|
| Definition | Banks multiply loans over reserves | Controlled by legal ratio & policies |
| Main Factor | Initial deposit in banks | Reserve ratio, cash availability |
| Effect on Money Supply | Increases overall supply | Prevents unlimited expansion |
Credit Creation Example: Stepwise Solution
| Step | Action | Example Data |
|---|---|---|
| Step 1 | Identify the Cash Reserve Ratio (CRR) | CRR = 20% = 0.20 |
| Step 2 | Calculate the Money Multiplier | 1 / 0.20 = 5 |
| Step 3 | Multiply Multiplier with Initial Deposit | ₹10,000 × 5 = ₹50,000 |
This means an initial deposit of ₹10,000 can potentially lead to a total credit creation of ₹50,000, assuming the reserve ratio and other assumptions hold true throughout the cycle.
Applications and Importance
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Economic Growth:
Credit creation increases purchasing power and supports business activity, investments, and overall economic development.
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Medium of Exchange:
New deposits act as a principal medium of exchange, making it easier for businesses and individuals to transact.
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Monetary Policy Transmission:
Changes in reserve ratios directly affect credit creation ability, making it a powerful policy tool for the central bank.
To master credit creation, revise the step-by-step calculation process, and understand how central bank policies and public behavior influence the banks’ capacity to generate credit. Practicing numerical questions, along with theory, supports both competitive and board exam readiness.
Next Steps and Vedantu Resources
- Review Commercial Banks: Types & Functions for more context on banking operations.
- Practice questions and summaries from Money and Banking Notes to reinforce learning.
- Test yourself on the credit creation formula and process for exam readiness.
FAQs on Credit Creation by Commercial Banks: Process, Formula & Examples
1. What is the process of creation of credit by banks?
The process of credit creation by banks involves accepting deposits and then lending a portion to borrowers. Banks keep a required reserve and loan out the rest, leading to multiple deposits being created in the banking system, expanding the total money supply.
2. Which bank makes credit creation?
Commercial banks are mainly responsible for credit creation. These banks accept public deposits and use a part of them to provide loans, increasing the overall amount of credit in the economy through repeated lending and deposit cycles.
3. What is credit creation by commercial banks known as SLR?
Credit creation by commercial banks is influenced by the Statutory Liquidity Ratio (SLR). SLR is the minimum percentage of deposits banks must keep in liquid assets, like cash or government securities, which limits how much credit banks can create with their deposits.
4. When does the process of credit creation by commercial banks come to an end?
The process of credit creation ends when banks cannot lend further. This usually happens when banks reach their required
- Statutory Liquidity Ratio (SLR)
- Cash Reserve Ratio (CRR)
5. Why is credit creation important for the economy?
Credit creation by commercial banks is important because it increases the money supply, helping businesses and individuals get more funds for spending or investments. This process supports economic growth, employment, and keeps the financial system functioning smoothly.
6. How is the amount of credit created by commercial banks calculated?
The amount of credit created depends on the deposit multiplier. This is calculated as $\frac{1}{ ext{Reserve Ratio}}$. For example, if the reserve ratio is 10% ($0.10$), the multiplier is $10$, so $\$1,000$ in deposits can generate $\$10,000$ in credit.
7. What factors limit credit creation by commercial banks?
Several factors limit credit creation, such as
- high reserve requirements (SLR, CRR)
- low public demand for loans
- lack of eligible borrowers
- banking regulations
8. What is SLR and how does it affect credit creation?
SLR (Statutory Liquidity Ratio) requires banks to keep a fixed portion of their deposits in safe and liquid assets. This reduces the funds available for loans, thereby restricting the credit creation process by commercial banks.
9. What role does the central bank play in credit creation?
The central bank regulates credit creation by setting ratios like SLR and CRR. These guidelines control how much commercial banks can lend, ensuring stability in the banking system and avoiding excessive growth in the money supply.
10. Can credit creation increase inflation?
Yes, credit creation can increase money supply, which may lead to higher demand for goods and services. If supply does not match demand, prices rise, causing inflation. Therefore, central banks monitor and regulate credit expansion carefully.
