SLO

Understanding Banking Business and Functions [Part-II]

Credit Creation

Concept of credit creation

Credit is created by commercial banks in two ways- advancing loans and by purchasing securities.

  • Banks maintain some part of deposits as liquid cash termed as cash reserve. This is in minimum requirement as specified by RBI. The excess or surplus is given out as loans and advances.
  • When giving a loan, banks open deposit account in the name of the borrower. This is known as secondary or derivative deposit.
  • The deposit left after giving out loans is known as credit multiplier. Thus, credit is created from secondary deposits.
  • Credit multiplier indicates the number of times primary deposits are multiplies and is the inverse of CRR.
  • Thus, the entire process of credit creation rests on the following assumptions:
  • Banking system is fully developed
  • Transactions are through cheques
  • Excess of CRR is kept as cash
  • Credit policy stays the same.

Merits and demerits of credit creation

Merits:

  • Banks are able to diversify risks with the help of credit creation.
  • The loans and advances are generally done from excess or surplus reserves.
  • This money which is lying passive joins the active process of credit creation

Demerits

Banks have to face a lot of limitations for successful credit creation.

  • It is directly dependent on the volume of excess reserves available with the banks.
  • CRR-the minimum cash limit of the bank which varies from 3-15%. Any increase in CRR leads to less credit.
  • Risk-averse nature of customers which makes them keep some cash with them for emergencies while banks prefer giving more loans to keep credit creation going.
  • Periods of economic recessions call for less loan demands from the customers.

Different types of credits

The need for credit comes from demand and supply side of the economy. The consumers of demand side require credit to acquire simple assets like consumer durables. The demand for credit from supply side corporate houses arises due to their needs for long-term investments. Types of loans:

Commercial loans: Loans which are given to supply side. These are given for 2 purposes:

  1. For acquiring fixed assets
  2. For maintaining the business

Individual loans: Loans which are given to demand side. These are given for 3 broad purposes:

  1. Consumption
  2. Acquiring durables
  • Housing finance

Installment credit: Credit amount is decided in advance and the amount is disbursed  either in stages or all at once. It is however, repaid in installments.

Operating credit: This is given to meet the daily credit requirements for operations. Banks decide the credit limit and provide a current account from which money can be withdrawn.

Receivable finance: Credit is in form of bills of finance.

Types of Loans

There are various types of loans or advances, which can be divided on the basis of different sets of criteria. They include non-fund based / fund based loans; secured / unsecured loans; term /  demand loans; personal / commercial loans; working capital / project finance; priority sector loans; MSME credit; rural / agricultural loans, retail loans etc.

Non-fund based lending and fund based lending

The Fund based lending is direct form of loans on which actual cash is given to the borrower by the bank. Such loan is backed by primary and / or a collateral security.

In Non-fund based lending, bank does not make any funds outlay but only gives assurance. The “letter of credit” and “bank guarantees” fall into the category of non-funding loans. The non-funding loan can be converted to a fund-based advance if the client fails to fulfill the term of contract with the counterparty. In banking language, the non-funding  advances are called Contingent Liability of the banks.

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