In very simple terms, a bank is separated from other financial banks by credit creation. Credit Creation is the expansion of the deposits. Also, the banks can expand their demand deposits as a multiple of their cash reserves because the demand deposits serve as a principal medium of exchange.
Demand deposits are a very crucial constituent of the money supply. The expansion of the demand deposits means the expansion of the money supply. The entire banking structure is based on credit. The meaning of credit is to get the purchasing power now and promise to pay at some time in the future. And bank credit means the bank loans as well as the advances. A bank keeps a certain part of its deposits as a minimum reserve to meet the demands of its depositors and the rest is lending out to earn an income. The account of the browser is given the loan. Every bank creates an equivalent deposit in the bank. Hence, credit creation means expanding bank deposits.
The Two Pivotal Aspects of Credit Creation
Liquidity
The banks are bound to pay cash to their depositors when they exercise their right to demand cash against their depositors.
Profitability
The banks always look for profit. They are profit-driven enterprises. This is the reason why a bank must grant loans in such a manner that will help to earn higher interest than what it pays on its deposits.
The bank’s credit process is based on the assumption that at any time only a few customers will genuinely need cash. Also, on the other hand, the banks assume that all their customers will not turn up demanding cash against their deposits at one point in time.
Know About the Basic Concepts of Credit Creation
1. Bank as a business institution
One has to believe that banks are a business institution that always tries to maximize profits through loans and the advances from the deposits.
2. Bank Deposits
Bank deposits are the basis for credit creation. Bank deposits are of two types as follows:
a. Primary Deposits-
A bank accepts cash from the customers and opens a deposit in his or their name. This is called a primary deposit and this does not mean a credit creation.
These deposits are simply converted into deposit money from currency money. These deposits form the basis for credit creation.
b. Secondary or Derivative Deposits-
A bank grants loans and advances. Instead of giving cash to the borrower, the bank opens a deposit account in his or her name. This is called the secondary or derivative deposit.
Every loan creates a deposit and the creation of a derivative deposit means the creation of the credit.
Process of Credit Creation by Commercial Banks
A central bank is the primary source of money supply in an economy of a nation through the circulation of currency. It ensures the availability of the currency for meeting the transaction needs of an economy. It also facilitates various economic activities such as production, distribution as well as consumption. For this purpose, the central bank needs to depend upon the reserves of the commercial banks which are the secondary source of money supply in an economy.
The most crucial purpose of a commercial bank is the creation of credit. This is the reason why the money supplied by commercial banks is called credit money. All commercial banks create credit by advancing loans and purchasing securities. They lend money to the individuals as well as to the businesses out of deposits accepted from the public.
Commercial banks are not allowed to use the entire amount of public deposits for lending purposes. They are accepted to keep a certain amount as a reserve with the central bank. This is for serving the cash needs of the depositors.
The commercial banks can lend the remaining portion of the public deposits after keeping the expected amount of reserves.
Factors affecting Credit Creation by Commercial Banks
Factors that have an Effect on the Creation of Credit are as follows:
The capacity of the bank banks to create credits which are a matter of the availability of cash deposits with banks. Also, the capacity to create credit depends on the factors that determine their cash deposit ratio.
The desire of the banks to create credits.
The demand for credit in the market.
Advantages and Limitation of Credit Creation by Commercial Banks
On the advantageous side, the depositors can access a wider range of products that the intermediaries offer that can easily be converted into cash. Investment of the company shares (mutual funds) can also be liquidated in a very easy manner.
On the disadvantageous side, there are several limitations, these are as follows:
Lack of securities.
The Business Environment
Lack of Cash
The habits of the people
Leakages
