Credit Creation by Banks
Transcript of Credit Creation by Banks
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CREDITCREDIT CREATIONCREATION
BYBY BANKSBANKS
y Central Bank is the first source of moneysupply in the form of currency in circulation.
y
The RESERVE BANK OF INDIA is the noteissuing authority of the country. The RBI ensuresavailability of currency to meet the transactionneeds of the economy.
y The total volume of money in the economyshould be adequate to facilitate the various typesof economic activities such as production,
distribution & consumption.
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y The commercial banks are the
second most important sources of
money supply.
THE MONEY THAT COMMERCIALBANKS SUPPLY IS CALLED
CREDIT MONEY.
yThe process of CREDIT CREATIONbegins with banks lending money out of
primary deposits.
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Primary deposits are those deposits
which are deposited in banks.
In fact, banks cannot lend the entire
primary deposits as they are required to
maintain a certain proportion of primary
deposits in the form of reserves with theRBI under RBI & BANKING
REGULATION ACT.
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yAfter maintaining the required reserves,
the bank can lend the remaining portionof primary deposits. Here banks lend the
money and the process of credit creation
starts.
EXAMPLE :-
Suppose there are a number of commercialbanks in the banking system- bank1, bank2,
bank3, so on.
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yTo begin with let us suppose that an
individual A makes a deposit of
Rs.100 in bank1.
y
Bank1 is required to maintain a cashreserve requirement of 5%
(prevailing rate) which is decided by
the RBIs monetary policy, from thedeposits made by A.
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yBank1 is required to maintain a cash
reserve of Rs.5 (5% of Rs.100). The
bank has now lendable funds of
Rs.95 (Rs.100-5).
yLet the bank1 lend Rs. 95 to a
borrower; say B. The method of
lending is the same that is bank1opens an account in the name of the
borrower for the loan amount.
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y At the end of the process of deposits &
lending, the balance sheet of bank reads as
given below:-
LIABILITIES AMOUNT ASSETS AMOUNT
As deposits 100 Cash reserve 5
Loan to B 95
TOTAL 100 Total 100
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yNow suppose that money
borrowed from bank1 is paid to
individual C in settlement of his
past debts.
yThe individual C deposits the
money in his bank say, bank2. Now
bank2 carries out its bankingtransaction.
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y It keeps a cash reserve to the extent
of 5%, that is Rs.4.75 (5% of Rs.95)
and lend Rs.90.5 to a borrower D.
At the end of the process thebalance sheet of bank2 will look
like:-
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LIABILITIES AMOUNT ASSETS AMOUNT
Cs deposits 95 Cash
reserve
4.75
Loan to D 90.5
TOTAL 95 TOTAL 95
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yThe amount advanced to D will returnultimately to the banking system, as
described in case of B and the processof deposits and credit creation willcontinue until the reserve with thebanks reduced to zero.
yThe final picture that would emerge atthe end of the process of deposit &credit creation by the banking system ispresented in the consolidated balancesheet as under:-
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BANK LIABILITIES
DEPOSITS
ASSETS
CREDITS
RESERVE TOTAL
ASSETS
Bank1 100 95 5 100
Bank2 95 90.5 4.75 95Bank3 90.5 85.98 4.52 90.5
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Bank n 00 00 00 00
TOTAL 2000 1900 100 2000
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y It can be seen from the combinedbalance sheet that a primary
deposits of Rs.100 in bank1 leads tothe creation of the total deposits ofRs.2000.
y It maintained a total cash reserve ofRs.100 which equals the primary
deposits. The total deposit createdby the commercial banks constitutesthe money supply by the banks.
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CONCLUSION
y To conclude, we can say that credit creationby banks is one of the important & only
sources to generate income.
y When the reserve requirement is increased
by the CENTRAL BANK it would directly
affect on the credit creation by bank becausethen the lendable funds with the bank
decreases and vice versa.