Credit Creation by Commercial Bank: Formula, Limitations (2024)

The process of credit creation is considered one of the most important functions performed by a commercial bank.

The central bank of a country is responsible for ensuring the supply of money in the economy by circulating the currency. It also ensures that for fulfilling all the transactions, there should be appropriate currency in the system.

This process cannot be implemented by the central bank alone. For this, they require the help of commercial banks and their reserves. Commercial banks perform the function of credit creation in an economy.

Therefore, the money that is created by commercial banks is known as credit money. This is achieved by the commercial banks in the form of purchasing securities and providing loans. The commercial banks facilitate the loans by utilising the deposits that are obtained from the public.

There are restrictions on the amount of money that can provide credits from the total deposits that a bank obtains from the public. As per the rule, the commercial banks need to maintain a certain portion of the public deposits as reserves with the central bank that will be used for meeting the immediate cash requirements of the depositors.

Only after keeping aside the required amount of those reserves the commercial banks are permitted to lend those amounts to individuals or businesses.

Also see:

  • Difference Between Central Bank and Commercial Bank
  • MCQs on Commercial Banks

Formula for determining the Credit creation

The following formula can be used to determine the total credit creation.

Total credit creation = Original deposit ✕ Credit multiplier coefficient


Credit multiplier coefficient = 1/r

r = Cash reserve requirement also known as cash reserve ratio (CRR)

Let us understand this with an example.

If the money deposited in a bank is ₹10,000 and the bank has a CRR of 10%, then what will be the credit multiplier coefficient?

Credit multiplier coefficient = 1/10%

= 1/0.1

= 10

Total credit creation = 10,000 ✕ 10 = 1,00,000

Similarly, if CRR = 20%


Credit multiplier coefficient = 1/20%

= 1/0.2

= 5

Therefore, total credit creation = 10,000 ✕ 5 = 50,000

From the given values we can understand that, a low CRR value results in high credit creation and a high CRR results in low credit creation. Therefore, with the help of credit creation, the money gets multiplied in the economy.

However, the commercial banks face many challenges and limitations while performing the credit creation in an economy are further discussed.

Also read:Functions of Commercial Banks

Limitations of Credit Creation

The following are some of the limitations that are experienced by the commercial banks during the credit creation process.

  1. Cash amount present in the bank

The higher the amount of deposits made by the public, the higher credit creation from the commercial banks can be seen. However, there is a certain limit on the amount of cash that can be held by the banks at a time.

This limit is determined by the central bank, as the central bank may contract or expand this limit by selling or purchasing the securities.

  1. Cash reserve ratio or CRR

It refers to the amount of money in the form of reserve that needs to be kept with the central banks by the commercial banks. This amount is used for meeting the cash requirements of the users. Any fall in the CRR will lead to more credit creation.

  1. Excess reserve

This takes place when a country faces recession, at that time the banks find it conducive in maintaining reserves in place of lending that leads to less credit creation.

  1. Currency drainage

It refers to the situation when the public is not depositing money in the banks. This results in reduced credit creation in the economy.

  1. Borrower availability

Credit creation will flourish if there are borrowers. The credit creation will not be done if there are no borrowers of the money in an economy.

  1. Prevalent business conditions

If an economy is witnessing a depression, then the businesses will not be seeking credit that leads to contraction of credit creation. Whereas, if a nation is prospering, then the businesses will seek new funds in the form of credit from the banks that would lead to credit creation.

Conditions Essential for Credit Creation

The following conditions are essential for credit creation in an economy.

  1. Willingness of public depositing money into the commercial banks
  2. Willingness of commercial banks to lend money to individuals or businesses in the form of credit
  3. Willingness of individuals or businesses in seeking money from the commercial banks in the form of credit

This was all about the concept of credit creation that plays an important role in the economy of a nation. For more such interesting concepts on economics for class 12, stay tuned to BYJU’S.

Related read:

  • Functions of the Central Bank
  • Money and Banking
Credit Creation by Commercial Bank: Formula, Limitations (2024)


What are the limitations of credit creation of a commercial bank? ›

Limitations of Credit Creation

This limit is determined by the central bank, as the central bank may contract or expand this limit by selling or purchasing the securities. It refers to the amount of money in the form of reserve that needs to be kept with the central banks by the commercial banks.

What is the formula of credit creation by bank? ›

In short, money (or credit) creation by commercial banks depends on two factors: (i) amount of initial deposit and (ii) LRR. Symbolically: Total credit creation = Initial deposit × (1/LRR)

What are the limitations of credit control? ›

Limitations of Credit Control
  • To be successful in a credit control programme, you must have complete control over the money market, however, this is not always achievable.
  • Credit control methods can only affect a short-term loan due to the various terms of the loan period.

What determines the credit creation capacity of a commercial bank? ›

The credit creation process of commercial banks is determined by the amount of initial deposits and the cash reserve ratio.

What is credit creation and its limitations? ›

Credit creation expands the availability of money in an economy through commercial banks and the country's other financial institutions. A country's central bank regulates credit creation by ensuring the maintenance of adequate reserves within the baking system and uses quantitative measures to control credit.

Which of the following is a limitation of credit creation? ›

Limitations of Credit Creation

There is a negligible chance of the loans turning into bad debts. The interest rate that banks charge on loans and advances is greater than the interest that the bank gives to depositors for the money deposited in the bank.

What is the credit formula? ›

What's in my FICO® Scores? FICO Scores are calculated using many different pieces of credit data in your credit report. This data is grouped into five categories: payment history (35%), amounts owed (30%), length of credit history (15%), new credit (10%) and credit mix (10%).

Which of the following statements is true about credit creation by banks? ›

Hence, the correct answer is banks create credit based on advances.

What is credit creation by banks example? ›

Credit Creation by Commercial Banks - Example

Lending: The bank decides to lend the $900 to a small business for expansion. New Deposit: The small business receives the loan, and the $900 is deposited back into the banking system. This creates a new deposit.

Which 2 methods are used when setting credit limits? ›

The first is the credit limit is based on top line sales volume as reported on the customer's Income Statement. The second is that the credit limit is based on the amount the customer purchases from the creditor meaning their sales volume.

What are the limitations of central banks? ›

Central Banks have limited control over the economy. They can influence it through monetary policy tools like interest rates, but they cannot directly control factors like consumer spending, business investment, technological changes, etc.

Which one of the following does not affect the credit creation ability of commercial banks? ›

Answer. The right answer to the above-given question is cash deposit ration. The term cash deposit ratio can be defined as the ratio of the amount that the bank has lent out from the deposits that have been mobilized.

How to control credit creation by commercial banks? ›

Open market operations refers to buying and selling of securities in an open market, in order to affect the money supply in the economy. The selling of securities by Reserve Bank of India will wipe out extra cash balance from the economy, thereby limiting the money supply resulting in controlled credit creation.

How central bank control credit creation by the commercial banks? ›

One way central banks accomplish this aim is by controlling the amount of money circulating in the economy. Their tools include influencing interest rates, setting reserve requirements, and employing open market operation tactics, among other approaches.

How do commercial banks control credit? ›

Bank Rate Policy- The bank rate is the lowest rate at which a country's central bank will lend money to its commercial bank and RBI utilizes it to regulate the credit in the economy. Because the central bank provides funding to the commercial banks by rediscounting bills, it is also known as the discount rate.

What are the disadvantages of commercial banks explain? ›

Disadvantages of commercial banks are as follows: The funds received from the commercial banks are of short duration and the procedure of obtaining funds is a time taking affair as there is a lot of verification that needs to be done from the bank end. The bank can set difficult conditions for granting of loans.

What are credit limits in business? ›

The term “credit limit” refers to the maximum amount of credit your company can extend to a client. This means that you will agree to provide the goods or services your client wishes to purchase without receiving immediate payment for the corresponding invoice.

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