Credit Creation by Commercial Bank – Meaning, Process and FAQs (2024)

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

  1. Liquidity

The banks are bound to pay cash to their depositors when they exercise their right to demand cash against their depositors.

  1. 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:

  1. 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.

  2. The desire of the banks to create credits.

  3. 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:

  1. Lack of securities.

  2. The Business Environment

  3. Lack of Cash

  4. The habits of the people

  5. Leakages

Credit Creation by Commercial Bank – Meaning, Process and FAQs (2024)


Credit Creation by Commercial Bank – Meaning, Process and FAQs? ›

Credit creation is the process where banks generate new deposits by lending money out. It begins when a bank extends a loan to a customer and simultaneously creates a deposit account in their name. The loaned money is then spent and usually ends up in a different bank, increasing the deposits in the banking system.

What is the process of credit creation by the commercial bank? ›

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.

How do commercial banks create deposits explain with the help of a numerical example? ›

Money creation is determined by: i The amount of the initial fresh deposits. ii The Legal Reserve Ratio LRR. It is the minimum ratio of deposits legally required to be kept as cash by the banks. Total Money Creation = Initial Deposits x 1/LRRExample: Let the LRR be 20% Fresh deposits = Rs.

What are the limitations of the credit creation process of commercial banks? ›

A bank cannot lend all of its funds. It has to keep a reasonable portion of its funds meet the demand of its customers(depositors). If more funds are required to meet the demand of depositors, then the power of credit creation will be lower.

What is the conclusion of credit creation? ›

Conclusion. The ability of commercial banks to create credit is a powerful force shaping the financial and economic landscape. Through the process of fractional reserve banking, where only a fraction of deposits is held as reserves, banks can multiply their lending capacity, thereby fueling economic activities.

How do you control credit creation? ›

Following increase in bank rate, market rate of interest is also raised, implying a check on borrowings from the Commercial Banks. Thus, overall supply of credit is reduced in the economy. Exactly opposite is done to combat deflation: bank rate is lowered to increase the supply of credit.

What is the process of money creation? ›

Banks create money by lending excess reserves to consumers and businesses. This, in turn, ultimately adds more to money in circulation as funds are deposited and loaned again. The Fed does not actually print money. This is handled by the Treasury Department's Bureau of Engraving and Printing.

What are the two methods by which commercial banks create money? ›

Commercial banks make money by providing and earning interest from loans such as mortgages, auto loans, business loans, and personal loans. Customer deposits provide banks with the capital to make these loans.

What is the process of credit creation in multiple banking system? ›

In the process of multiple credit creation, the total amount of derivative deposits that a bank creates is a multiple of the initial cash reserves. The banking system has many banks in it and it cannot grant loans in excess of the cash it creates. When a bank creates a derivative deposit, it loses cash to other banks.

What do commercial banks do with deposits? ›

Making loans

The process involves maturity transformation—converting short-term liabilities (deposits) to long-term assets (loans). Banks pay depositors less than they receive from borrowers, and that difference accounts for the bulk of banks' income in most countries.

What are credit risks in commercial banks? ›

Credit risk is the probability of a financial loss resulting from a borrower's failure to repay a loan. Essentially, credit risk refers to the risk that a lender may not receive the owed principal and interest, which results in an interruption of cash flows and increased costs for collection.

What is the effect of bank rate on credit creation by commercial banks? ›

An increase in the bank rate will cause the banks to increase the interest at which they lend. This in turn will discourage businessmen to borrow from banks and lead to an overall reduction in the volume of credit.

Which of the following will limit the process of credit creation? ›

Important Points Factors that reduce credit creation: Cash in hand: If people start making the use of cash in hand, they will deposit less and less money with the bank. This will result in less amount of cash left with the bank due to which the credit creation capacity of the bank will fall.

Is credit creation good or bad? ›

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.

How do commercial banks create money in a reserve banking system? ›

Commercial banks make money by offering loans and charging interest, such as mortgage debt, auto loans, business loans, and secured loans. Customer reserves provide the capital for banks to make these lending. Commercial banks begin creating money when individuals deposit money into their bank accounts.

Why is creating credit important? ›

In addition to having higher credit approval rates, people with good credit are often offered lower interest rates. Paying less interest on your debt can save you a lot of money over time, which is why building your credit score is one of the smartest financial moves you can make.

When the process of credit creation by commercial banks comes to an end? ›

Solution. The following statement is correct. "The credit creation process by commercial banks concludes when the total of required reserves equals the initial deposits."

What is the effect of an increase in bank rate on credit creation by commercial banks? ›

Increase in bank rate will make the loans more expensive for the commercial banks, therefore pressurizing the banks to increase the rate of lending. The public capacity to take credit will gradually fall leading to the fall in the volume of credit demanded. The reverse happens in case of a decrease in the bank rate.

What is credit control by the central bank? ›

Credit Control is a role of the Reserve Bank of India's central bank, which regulates credit, or the supply and the demand of money or liquidity in the economy. The central bank controls the credit extended by commercial banks to their customers through this function.

What is meant by commercial bank? ›

What is Commercial Bank? A commercial bank is a kind of financial institution that carries all the operations related to deposit and withdrawal of money for the general public, providing loans for investment, and other such activities. These banks are profit-making institutions and do business only to make a profit.

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