Explain the Process of Credit Creation by Commercial Banks. (2024)

The process of credit creation by commercial banks can be easily understood by the following example.

Suppose a person, say X, deposits ₹ 2000, with a bank and the LRR is 10% which means the bank keeps only the minimum required ₹ 200 as cash reserve.

The bank can use the remaining amount ₹ 1800 (= 2000-200) for giving a loan to someone. The bank lends ₹ 1800 to, say F, for this purpose and an account is opened in the name of Y and the amount is credited in his account. This is the first round of credit creation in the form of a secondary deposit (₹ 1800) which equals 90% of the initial deposit.

Now again from the deposit of Y, the bank keeps 10% or LRR i.e., 180 and remaining ₹ 1620 is advanced to, say, Z. The bank gets a new demand deposit. This is the second round of credit creation till secondary deposit becomes zero. In the end, the volume of total credit created becomes multiple of the initial deposit.

The quantitative outcome is called money multiplier. 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)

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Explain the Process of Credit Creation by Commercial Banks. (2024)


Explain the Process of Credit Creation by Commercial Banks.? ›

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.

What is the process of credit creation by 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.

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

Credit Creation Process: Begins when a depositor places money in a bank, the bank reserves a portion (known as the reserve ratio) and lends out the rest, creating a secondary deposit, and the process repeats, expanding the money supply in the economy.

What is the creation of credit by the central bank? ›

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.

What is the process of deposit creation? ›

Deposit creation is the process of a customer depositing money into a bank, leading to an increase in the bank's assets. It's essential for the financial stability of the banking sector.

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 meant by commercial bank? ›

A commercial bank is a financial institution that performs operations related to deposit and withdrawal of money for the public, provides loans for investment, and carries out other similar activities. The two main functions of a commercial bank are lending and borrowing.

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.

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.

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

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

Do banks create money or credit? ›

Banks create money when they lend the rest of the money depositors give them. This money can be used to purchase goods and services and can find its way back into the banking system as a deposit in another bank, which then can lend a fraction of it.

How does central bank control flow of credit? ›

Control through the directives- The central bank uses this strategy to issue regular directives to the commercial banks. Commercial banks are guided by these directives in developing their lending policies. The central bank can use a directive to alter credit structures and limit credit supply for a specified purpose.

Can central bank create credit money? ›

It is the sole agency of note issuing and controls the supply of money in the economy by controlling the amount of credit creation in the economy. Therefore, the main function of central bank is to control the amount of credit and not to create it.

How to commercial bank create a deposit? ›

They create credit in the form of demand deposits. Demand deposits of the Commercial Banks are many times more than their Cash Reserves. Money creation is determined by: i The amount of the initial fresh deposits. ii The Legal Reserve Ratio LRR.

What is an example of deposit creation? ›

The multiple deposit creation process works like this: say that the central bank buys $100 of securities from Bank 1, which lends the $100 in cash it receives to some borrower. Said borrower writes checks against the $100 in deposits created by the loan until all the money rests in Bank 2.

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

In simple terms, credit creation is the expansion of deposits. Banks can expand their demand deposits as a multiple of their cash reserves because demand deposits serve as the principal medium of exchange. Commercial Banks create credit by advancing loans and purchasing securities.

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 the credit control method? ›

Credit control is defined as the lending strategy that banks and financial institutions employ to lend money to customers. The strategy emphasises on lending money to customers who have a good credit score or credit record.

How to 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.

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