Banking Business and Functions-2

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
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