Do Bank Create Credit

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Assignment of Money, Banking and Finance

Topic: Do banks Create Credit?

Submitted to:

Miss Sundas Shahnawaz

Submitted By:

Humayun Khalid Qurashi

B.com (Hons) 3rdSemester

Roll # 04/Regular

[email protected]

Department of Commerce


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Do Banks Create Credit?

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Contents at Glance

Sr.# Topics Page. #

1 Preface 5

2 Introduction of Credit Creation 6

3 Process of Credit Creation 6

4 Contraction of Credit 10

5 Limitations of Credit Creation 11

6 References 12


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Preface

This assignment includes on the Credit Creation, its Contraction and Limits of Credit

Creation. What is Credit Creation and how its created by Commercial banks. Credit

Creation Examples will clarify the Process of Credit Creation.

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What is Credit Creation?

Credit Creation does not mean that banks mint notes and coins. By creation of credit it

meant that the commercial banks by taking on deposits and making loans expend the moneysupply and circulation.

A question is that Do Banks Actually Create Credit?

The answer is Yes. Creation of credit does not mean minting of money. It is the expending of

money supply by banks by taking deposits and making loans. Credit Creation is one of the

important functions of commercial banks. Credit creation is the multiple expansion of banks

demand deposits. It is an open secret that banks advances a major potion of their deposits to the

borrowers and keeps a smaller part of them for payments to the consumers on demand.

Even the customers of banks have fully confidence that their deposits lying in the banks are quite

safe and can be drawn any time on demand. This tendency on the part of commercial banks to

make loans several times of the excess of cash reserves kept by the banks is called Credit

Creation.

Process of Credit Creation

A single bank cannot create loans. Whole banking system works for credit creation. it is

the multiple expansions of banks demand deposits. This cannot happen in the single bank

economy and it is applicable only in the two or more banks economy. One bank opens a depositaccount in the name of the debtor and allows him to draw when required. Through this process

the loan advanced becomes the gain of deposit by some other bank. In this way loans become

the deposits and the deposits appear as loans.(Ref 1)

Example

Let us assume that there are more then one banks in the country. It is further assumed

that the required reserve ratio* is 20%. Mr. Ali deposits Rs. 1000 in the MCB. For simplicity sake

we will show new changes in the assets and liabilities only. The balance sheet of MCB now

appears as under:

MCBLiabilities RS. Assets Rs.

Demand Deposits 1000 Cash received 1000


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We assume now that Mr. Burhan approaches MCB for loan. The MCB sets aside 20% or Rs. 200 of

new deposit as required reserves and the balance of Rs.800 is loaned out to Mr. Burhan the

balance sheet ofMCB after giving loan would be as under:

MCBLiabilities RS. Assets Rs.

Demand Deposits 1000 Cash Reserves 200

---- Loan to Mr. Burhan 800

Total 1000 Total 1000

We now assume that the borrower Mr. Burhan makes a payment of Rs. 800 by cheque to Mr.

Ahmad to pay off his debt. Mr. Ahmad has an account in Habib Bank Ltd. and he deposits this

amount in his account. The Habib Bank receives Rs. 800 as deposit and its balance sheet now

appears as under:

Habib Bank Ltd.Liabilities RS. Assets Rs.

Demand Deposits 800 Cash received 800

We further assume that Mr. Furqan approaches Habib Bank Ltd. for loan. The Habib bank keeps

20% of Rs.800 as cash reserves (Rs.160) and the balance amount of Rs. 640 is given as loan to Mr.Furqan the balance sheet ofHabib Bank Ltd. will now appears as follow.

Habib Bank LtdLiabilities RS. Assets Rs.

Demand deposits 800 Cash Reserves 160

---- Loan to Mr. Furqan 640

Total 800 Total 800

Mr. Furqan utilizes the loan of Rs.640 to pay off debt to Mr. Mutee-ur-Rahman who deposit thisamount in his bank named as Habib Metropolitan. The balance sheet ofHabib Metropolitan

increases by Rs.640. the Habib Metropolitan bank also keep 20% as required reserves (Rs.128)

and gives excess reserves of Rs.512 as loan to Mr. Zaheer. The amount loaned out to Mr. Zaheer

becomes a new deposits at another bank named as Atlas bank. If the process of creating

secondary deposits is continued, then at each stage in this sequence, the amount of new loan

gets smaller and smaller.


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The initial or primary deposit of Rs. 1000 with bank MCB, leads to the creation of secondary

deposits of Rs. 800 in the first round, Rs. 640 in the second round, Rs. 512 in the third round and

so on and so forth. The total increase in the deposits from the initial Rs. 1000 increase in reserves

is 5000. The increase in five fold, the reciprocal of the reserves requirements which is shown in

the table below. In case the require reserve ration is 10% and the initial increase in the reservesis RS. 1000, the credit expansion as a whole is Rs. 10,000. The increase is ten fold the reciprocal of

the reserve requirement =

Example of credit Creation by banking system (assuming 20% reserves requirements and a Rs.

1000 in deposits)

Banks Payment Deposit

(Rs.)

Cash reserves at 20%

(Rs.)

Credit Creation (Rs.)

MCB 1000 (initial) 200 800

Habib Bank LTd 800 160 640

Habib Metopolitan Bank 640 128 512

Atlas Bank 512 102 410

Bank A.B.C 410 82 328

Bank D.E.F 328 66 262

Bank G.H.I 262 52 210

Bank J.K.L 210 42 168

Bank M.N.O --- --- ---

Total 4162 832 3330

The table shows the following points.

If the cash reserve ratio is 20% and The initial deposit is Rs. 1000, the bank creates newly money of Rs.3330. the total

demand deposits are 4162 (Which are done) (initial deposit Rs. 1000+ credit creation)

Note=> All the Names and Figures taken are completely assumed and fictitious.


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Deposit Chain of Credit Creation by different banks:

Rs. 1000 (initial deposit)

Rs.160

reserves

Rs.800 lent

out

Rs.800 deposit

Rs. 200 on

reserve

Rs. 640 lent

out

Rs. 640 deposit

Rs. 128

reserves

Rs. 512 lent

out

The Chain will be continue till the

deposit amount goes to an end


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Contraction of Credit

Just as deposit creates loans and loans create deposit, similarly the

withdrawal of deposit contracts credit. For example, if the cash reserves ratio is 20% the initialreduction is Rs. 1000 in bank MCB, will lead to a reduction of deposit of Rs.800 in Habib Bank Ltd,

and so on.

Credit Multiplier:

The credit creation by bank is influenced by credit multiplier. It is the

reciprocal of the required reserves.

With an initial deposit of Rs. 1000 in bank MCB the change in deposit is= Rs 1000 x 5 = Rs. 5000.

D= Represents the change in the Banking System as a Whole

R= Represents the Required Reserves Ratio

E= Represents the Primary Deposits


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Limits to Credit Creation:

The capacity of banks to create the credit is subject to certain limitations which

are given below.

1) Cash DrainIn the case of chain process of multiplier

expansion/contraction of credit, it is assumed that all payments

are made by cheques and not in cash form. In case,some

borrowers or most of borrowers withdraw a part or the entire

amount loaned to them in cash form, banks will not able to

create credit to the desire extent. An outflow of cash from the

reserves of banks will reduce their ability to expand deposits

and vise versa. There will be no reserves for common man.

2) Transfer of Deposits to Non bank Financial InstitutionsThe transfer of funds to non bank Financial Institutions can

also limit the credit creation ability of the banks.

3) Willingness to BorrowersThe banks may not be able to take full advantages of credit expansion if they are

unable to find sufficient qualified borrowers willing to apply for loan. This is likely to be in case

during a recession where banks confidence is low.

4) Different Types of Loans.It is assumed that all deposits in the banks are in the form of current deposits only. The

fact is otherwise. The banks keep a fairly large deposit in the form of saving and time deposits.

Conclusion:

To conclude, we can say that credit creation by banks is one of the important &

only sources to generate income. And when the reserve requirement increased by the

central bank it would directly affect on the credit creation by bank because then the

lendable funds with the bank decreases and vice versa. The multiple deposits creation

model seems to indicate that the Central Bank of the country has complete control over

the level of current deposits by setting up the required reserves ratio. The fact is that all

the four players i.e. the central bank, the commercial banks, depositors and the borrowers

are important in the determination of credit expansion.

************************************************

No Fair Credit for common

man


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Data References

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Book Reference

Money, Banking and Finance by M.Saeed Nasir

Web sites

http://en.wikipedia.org/

http://wiki.answers.com/

http://www.blurtit.com/
http://www.blurtit.com/http://www.blurtit.com/http://www.blurtit.com/

Do Bank Create Credit

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