CreditCreation:HowdoesCommercialBanksCreateCredit?bySupriyaGuruCommercialBanks

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Creationofcreditisoneofthemostoutstandingfunctionsofamodernbank.Abankhassometimesbeencalledafactoryforthemanufactureofcredit.Howcreditiscreated?Itisanopensecretthatthebanksdonotkeepcentpercentreservesagainstdepositsinordertomeetthedemandsofdepositors.

Thebankisnotacloakroomwhereyoucankeepyourcurrencynotesorcoinsandclaimthoseverynotesorcoinsbackwhenyoudesire.Itisgenerallyunderstoodthatmoneyreceivedbythebankismeanttobeadvancedtoothers.

Adepositorhastobecontentsimplywiththebankspromiseorundertakingtopayhimwheneverhemakesademand.Thusthebanksareabletodowithaverysmallreserve,becauseallthedepositorsdonotcometowithdrawmoneysimultaneouslysomewithdraw,whileothersdepositatthesametime.

Thebankisthusenabledtoerectavastsuperstructureofcreditonthebasisofasmallcashreserve.Thebankisabletolendmoneyandchargeinterestwithoutpartingwithcash,asthebankloancreatessimplyadepositoritcreatesacreditfortheborrower.Thisiswhatismeantbycreationofcredit.

Similarly,thebankbuyssecuritiesandpaysthesellerwithitsownchequewhichagainisnocashitisjustapromisetopaycash.The

chequeisdepositedinsomebankandadepositiscreatedorcreditiscreatedforthesellerofthesecurities.Thisiscreditcreation.

Thetermcreditcreationimpliesasituation,touseBenhamswords,whenabankmayreceiveinterestsimplybypermittingacustomertooverdrawtheiraccountsorbypurchasingsecuritiesandpayingforthemwithitsowncheques,thusincreasingthetotalbankdeposits.

Letusseetheactualprocess.Letusassumethatthereisonlyonebankinthecountry.SupposeacustomerdepositsRs.1,000inthebank.Thebankhastopayhiminterest.Therefore,thebankmustseekasafeandprofitableinvestmentforthisamount.Itmustlendittosomebody.Butthisamountisnotactuallypaidouttotheborroweritisretainedbythebanktomeetitsobligations,i.e.,topaytothoseofitsdepositorswhoneedcashanddrawchequesforthepurpose.

Thebanksexperiencetellshimthatforthispurposeonlyacertainpercentageofcashreservestototalliabilitiesneedbekept.IncountrieslikeEngland,theykeepnearly10percent.TheratioofcashreservestoliabilitiesismuchhigherincountrieslikeIndia,wherebankinghabithasyettodevelop.

Supposethebank,inwhichadepositorhasdepositedRs.1,000,keeps20percentcashreservetomeetthedemandofdepositors.Thismeansthat,assoonasthebankhasreceived1,000itwillmakeupitsmindtoadvanceloansuptotheamountofRs.5,000(onlyonefifthreserveiskept).When,therefore,abusinessmancomestothebankwitharequestforaloanofRs.5,000,hemaybesureofbeinggrantedaccommodationtothisextent,providedofcourse,hiscreditisgood.ThebanklendsRs.5,000,althoughithasonlyRs.1,000incash.Itisherethatcreditcomesin.

Thistransactionisrenderedpossiblebecausetheborrowerisnotgiventheloanincashonlyanaccountisopenedinhisnameandtheamountiscreditedtohisaccount.Heissimplygiventhechequebook,i.e.,therighttodrawchequesasandwhenheneedsmoney.Evenwhenhewithdrawscash,itwillbedepositedinthebankbytherecipients,becausebusinessmendonotraisefundstokeepthemlockedupinacashboxbuttoruntheirbusinessandtomakepaymentstotheircreditors.

Whenthisparticularbusinessmandrawschequesonthisbanktopayhiscreditors,thesechequesarepassedonbythemtotheirownbanks,wheretheamountisdepositedintheiraccount.Cashisseldomwithdrawn.Thebanksadjusttheirmutualobligationsthroughasystemofbankclearing.ThusthebankhassucceededincreatingacreditofRs.5,000againstacashreserveofRs.1,000.

Thebankalsocreatescreditwhenitpurchasessecurities.Thebankcanpurchasesecuritieswithoutpayinganycash.Itissuesitsownchequetopaythepurchaseprice.Thechequeisdepositedinthisbankorsomeotherbankandthesmallcashreservewhichthebankkeepsissufficienttomeetanobligationarisingfromthistransactiontoo.Itisthusthat,onasmallcashfoundation,avastsuperstructureofcreditisbuiltup.

Letusnowunderstandtheprocessofcreditcreationwhenthereareseveralbanksinthecountry,astheyareintherealworld.Inthecaseofseveralcommercialbanksinthecountry,oneindividualbankcannotcreateallthecreditasdescribedabove.Butwhatnosinglebankcandoindividually,thebankingsystemasawholecando,i.e.,createcredit.

Weshallexplaintheprocessofcreditcreationortheexpansionofmoneysupplyinthecountrybythebankingsystemcollectivelywith

thehelpofbalancesheetsofthebanks.WeshallillustratehowdepositofRs.1,00,000ofcurrencyinacommercialbankenablesthebankingsystemasawholetoexpanddepositsbyanotherRs.4,00,000,thatis,depositsofRs.1,00,000incurrencyleadstoatotaldepositsofRs.5,00,000inthebankingsystem.

Banks,asotherbusinessfirms,showtheirfinancialconditiononabalancesheet.Asimplebalancesheethastwocolumns,itsleftcolumnrepresentsalltheassetsofabankanditsrightcolumnrepresentsalltheliabilitiesofabank.Assetsareallthethingsorclaimsabankowns,liabilities,ontheotherhand,areclaimsagainstthoseassetssomeoftheclaimsareofcreditorsandsomeofthemareofownersofthebanksthemselves.Becauseassetsshoweverythingthatabankownsandbecauseliabilitiesrepresentclaimsagainstthoseassets,thetwosidesofthebalancesheet,thatis,assetsandliabilitiesmustequaleachother.

LetussupposethatanindividualorafirmdepositsRs.1,00,000incashwithabankA.Ignoringeverythingelseinthebalancesheet,letusknowhowthebalancesheetofbankAwilllooklikewiththisfreshdepositofRs.1,00,000incurrencywithit.ThecashofRs.1,00,000whichthebankAwillreceivewillbecomeitsassets,andatthesametimeindividualsdepositsofRs.1,00,000willbeitsliabilities,theassetsandliabilitiesofbankAwillthereforebeequaltoeachother.

BANKA:

BalanceSheet

Letusassumethatcashreserveratiois20%.Nowthebankdoesnot

requirealltheRs.1,00,000incashagainstthedepositsofRs.1,00,000.ThebankArequiresonly20%ofit,thatis.Rs.20.000cashagainstitsdepositsofRs.1,00,000.ThebankcanlendorinvestinsecuritiestheremainingamountofRs.80,000.Actuallyifthebankdoesnotlendorinvestitwillsufferaloss,sinceitwillpaytheinteresttothedepositorwithnoprofitfromthecashitpossesses.

Therefore,thebankAwilllendRs.80,000tothebusinessfirmsorindividualswhomitfindscreditworthy.Now,whenabanklendstoapersonorfirmitdoesnotgivehimcashimmediately.Thebankmakesdepositsinthenameofthepersonwhomhelendsthemoneyandgiveshimtherighttodrawchequesagainstitwhenrequired.Itisanewdeposit,onethatdidnotexistbefore.

Thepersonorfirmgettingloansfromthebankwill,however,aftersometimecompletelywithdrawthemoneythroughchequesfromhisdeposits.

WhentheloanofRs.80,000hasbeensanctionedtoaperson,butbeforethatpersonstartswithdrawinghismoney,thebalancesheetofbankAwilllooklikeasfollows:

BANKA

BalanceSheet

(WhenthebanksanctionsloanofRs.80,000butbeforeloaniscashed)

Inthisbalancesheet,loanofRs.80,000becomesassetofthebank,whilethenewdepositscreatedconstitutetheliabilityofthebank,sincethepersongettingtheloanhastherighttodrawuponthesedeposits.Now,whenthepersonwhollywithdrawshisdepositsthroughchequesandtherecipientsofthesechequesdeposittheminsomeotherbank,saybankB,thenthebankAwillhavetosurrendertobankBcashmoneyequaltoRs.80,000.

AfterthewholenewlycreateddepositsofRs.80,000havebeenthuswithdrawn,thebalancesheetofbankAwillnowlooklikeasfollows:

BANKA

BalanceSheet

Assaidabove,chequesworthRs.80,000againstBankAaredepositedinBankB,fortheBankBthesewillconstitutenewcashmoneyandwillthereforebecometheassetsofbankB.ButRs.80.000willalsobetheliabilityofthebankBintheformofdepositsinthenameofthosepersonswhohavedepositedthechequeswithit.

IgnoringotherassetsandliabilitiesofbankBandtakingintoaccountonlythisabovetransaction,thebalancesheetofbankBwillbeasfollows:

BANKB

NowagainstthedepositsofRs.80,000bankBrequirestokeepits20%,thatis,Rs.16,000anditcanlendorinvesttheremainingamountofRs.64.000.

WhenbankBlendsRs.64,000toafirm,itwillcreatedepositsforthatfirm.Beforethefirmdrawsuponthosedeposits,thebalancesheetofbankBwilltooklike:

BANKB

BalanceSheet

Now,whenthefirmwhichhasgotloanfrombankBcompletelywithdrawsRs.64,000throughcheques,thebalancesheetofbankBwillbeasfollows.AsaresultofthefirmspendingtheloanmoneyofRs.64,000,thebankBwilltransfercashofRs.64,000toanotherbank,sayC,inwhichthechequesdrawnbythefirmaredeposited.Asaresultofthis,thecashwithbankBwillfalltoRs.16,000(Rs.80,000Rs.64,000=Rs.16,000).

BANKB

BalanceSheet

NowwhenthebankCwillgetRs.64,000,itwillalsorequiretokeep20%ofit(i.e.,Rs.12,800)andtheremainingamountofRs.51,200willbelentoutorinvestedbyit.FromtheforegoinganalysisitisclearthatthecurrencydepositsofRs.1,00,000ledtothecreationofdepositsofRs.80,000byBankA,Rs.64,000byBankB,andRs.51,200byBankC.Buttheprocessofexpansionofdepositswillnotstophere,itwillgoonasthemoneylentoutbyonebankisspentthroughchequesandthesechequesaredepositedinotherbanks,tillthetotaldepositsofRs.5,00,000inallthebanks(includingoriginaldepositsofRs.1,00,000)arecreated.

Butitshouldberememberedthatateachstagethenewdepositscreatedbyabankgoesondeclining.Thisisbecauseateachstageabankisrequiredtokeep20%ofthemoneyitreceivesascashreservesandthereforelendsandcreatesdepositsequalonlytotheremainingamount.ThusbankAcreateddepositsofRs.80,000,bankBcreateddepositsofRs.64,000,bankCcreateddepositsofRs.51,200andsoon.

WearenowinapositiontostatehowmuchdepositshavebeencreatedbythebankingsystemoutofthecurrencydepositsofRs.1,00,000.

TotalDeposits=Rs.1,00,000+80,000+64,000+51,200+=Rs.5,00,000OutofthetotaldepositsofRs.5,00,000,thedepositsofRs.1,00,000incashwasmadeinthebankingsystem,theremainingdepositshavebeencreatedbythebankingsystemitself,asifoutofthinair.

Depositscreatedbythe=Rs.5,00,0001,00,000

bankingsystem=Rs.4,00,000

Itshouldbefurthernotedthatthetotalexpansionofdepositsbythebankingsystemdependsuponthecashreserveratio(CRR).Thesmallerthecashreserveratiothelargetheexpansionofdepositsorcredit.Thus,intheabovecase,wenotedthat,giventhecashreserveratioof20%,thetotaldepositsexpansionfromthecashdepositsofRs.1,00,000,wasequaltoRs.5,00,000.Thusthetotaldepositsexpandedtowasfivetimestheoriginalcashdeposits.

Thereforethedepositofcashinthebankingsystemleadstomultipleexpansionsinthetotaldeposits.Thisisknownasdepositsorcreditmultiplier.Inourabovecase,thedepositsorcreditmultiplieris5.Itshouldberememberedthatthemagnitudeofdepositsmultiplierdependsonthecashreserveratio.

Depositmultiplierdm=1/r

whererstandsforcashreserveratio.

Thusdepositmultiplieristhereciprocalofcashreserveratio(CRR)whichwehavedenotedbyrinthemeasureofdepositmultiplier.

Thus,whenthecashreserveratiois20%,thatis,0.20or1/5,thedepositmultiplier.

=1/1/5=5

Now,ifthecashreserveratioisraisedbyReserveBankto25percent,thatis,0.25,thedepositmultiplier,

dm=1/0.25=1/1/4=4

Thus,thegreaterthecashreserveratio,thelowerwillbethevalueofdepositmultiplier.Inotherwords,increaseinthecashreserveratio(CRRorr)willleadtothecontractionofcreditcreatedbythebanks,andviceversa.

Similarly,ifthecashreserveratiois10%,i.e.,1/10,thenthedepositsmultiplier=1/1/10=10.Inthiscaseinitialdepositsofsomecashamountinthebankingsystemwillleadtotentimesexpansioninthetotaldeposits.Figure11.1makescleartheprocessofdepositsexpansionbythebankingsystem.

DepositMultiplierandCreditMultiplier:

Someeconomistsdistinguishbetweendepositmultiplierandcreditmultiplier.Inouraboveexample,originalorprimarydepositsofRs.100,000madebythepublicinthebankingsystem,giventhecashreserveratio(r)equalto20percenti.e.0.20),resultedintheincreaseintotaldepositsinthebankingsystemequaltoRs.500,000.IfwedenotetotalincreaseindepositsbyADandoriginalincreaseincashdepositsasAR,thenthedepositmultipliercanbewrittenas

dm=D/R

or,inourfirstexample,dm=D/R=1/r=1/0.20=5

Now,inouraboveexampletheprimarycashdepositsofRs.100,000ledtothecreationofdeposits(i.e.increaseincredit)equaltoRs.4,00,000bythebankingsystemitselfwhenmakingloansorcreatingcreditforbusinessmen.

Thecreditmultipliermeasurestheextentbywhichthebankingsystemcreatescreditasaresultofnewincreaseinprimarydepositswhichtheyuseasreserves.IfwedenotecreditcreatedbythebanksasACandtheincreaseinprimarydepositsascashwiththebanksasAR,thencreditmultipliercanbewrittenas

Cm=C/R

WhereCmrepresentscreditmultiplier

Since

C=DR

Cm=DR/R=D/RR/R=D/R1

D/R=dm

Therefore,

Cm=dm1

=1/r1

=1r/r

LimitationsontheCreditCreatingPoweroftheBanks:

Fromtheforegoingaccountofcreditordepositscreationbythebanks,itwouldseemthatthebanksreapwheretheyhavenotsown.Theyadvanceloansorbuysecuritieswithoutactuallypayingcash.Buttheyearninterestontheloanstheygiveorearndividendsonthesecuritiestheypurchaseallthesame.

Thisisverytempting.Theymakeprofitswithoutinvestingcash.Theywould,ofcourse,liketomakeasmuchprofitlikethisastheycan.Buttheycannotgoonexpandingcreditindefinitely.Intheirowninterest,theyhavetoapplythebrake,andtheydoactuallyapplyit,foritiswellknownthattheprofitsmadebythebanksarenotveryhigh.Theoverridinglimitationarisesfromtheobligationofthebankstomeetthedemandsoftheirdepositors.

Benhamhasmentionedthreelimitationsonthepowersofthebankstocreatecredit:

(i)Theamountofcashinthecountry

(ii)Theamountofcashwhichthepublicwishestoholdand

(iii)Theminimumpercentageofcashtodeposits,calledcashrevenueratiowhichthebankshavetomaintain.

(iv)Theamountofmoneywhichthepublicwantstoholdasdepositsinthebanks.

Asfor(i),itmaybesaidthatcreditcanbecreatedonthebasisofcash.Thelargerthecash(i.e.,legaltendermoney)thelargertheamountofcreditthatcanbecreated.Buttheamountofcashthatabankmayhaveissubjecttothecontrolofthecentralbank.Thecentralbankhasthemonopolyofissueofcash.Itmayincreaseitor

decreaseit,andcreditwillexpandorcontractaccordingly.Thepowerofthecentralbanktocontrolcurrencyhelpsittocontroltheextentofcreditthatthebankshavethepowertocreate.

Thesecondlimitationarisesfromthehabitofthepeopleregardingtheuseofcashi.e.currency.Ifpeopleareinthehabitofusingcashandnotcheques,asinIndia,thenassoonascreditisgrantedbythebanktoaborrower,hewilldrawthechequeandgetcash.Whenthebankscashreservesarethusreduced,itspowertocreatecreditiscorrespondinglyreduced.

Ontheotherhand.Ifpeopleusecashonlyforverysmallandoddtransactions,thenthecashreserveofthebanksisnotmuchdrawnuponandtheirpowerofcreatingcreditremainsunimpaired.ThisisthecaseinadvancedcountriesliketheU.S.A.,EnglandandotherEuropeancountries.Therethebankshardlykeep10percentcashreserve.

Thethirdlimitationisthemostimportant.Itarisesfromthecashreserveratiocash,whichthebanksmustmaintaintoensurethesafetyofthebankandtoretainthedegreeofliquiditythatisconsidereddesirable.Itisclearthatwhenabankcreatesacreditorgrantsaloan,itundertakesaliability.Thereisanincreaseinitsliabilitiesandthereiscorrespondinglyafallincashreserveratio.Thebankwillnotletthecashreserveratiofallbelowacertainminimum.

Whenthatminimumisreached,thepowerofthebanktocreatecreditcomestoanend.Tograntanyfurthercreditwillberiskyunlessthebanksexperienceisreassuringenoughtopermittheadoptionofalowerpercentage.Thenthatwouldbethelimit.

Theotherimportantlimitationonthecreditcreatingpowerofbanks

istheamountofmoneywhichthepublicchoosetoholdasdepositsinbanks.Themoremoneywhichthepublicdepositswiththebanks,themorereservesbankswouldhaveandthereforemorecredittheywillbeabletocreateandviceversa.

Itmaynotedthatpubliccanusetheirsavedmoneyinmorethanoneway.Thepubliccanbuysharesordebentureofthecompanies,itcaninvestinmutualfundsofbothpublicandprivatessectors.Butthecreditcreationbythebanksdependsonthemoneythepublicdepositsinthem.Itisimportanttonotethanrateofinterestpaidbythebanksondepositsdeterminestoagoodextenttheamountofmoneydepositswiththembythepublic.Otherthingsbeingequal,thehighertherateofinterest,thegreatertheamountofmoneythepublicwilldepositmoneywiththebanks.

Tothesemaybeaddedthefourthlimitation.Thebankcannotcreatecreditwithoutacquiringsomeasset.Anassetisaformofwealth.Thusthebankonlyturnsimmobilewealthintomobilewealth.Hence,asCrowtherobserves,thebankdoesnotcreatemoneyoutofthinair,ittransmutesotherformsofwealthintomoney.However,bankingsystemtodayhasbecomequiteadvanced.Thesedaysbanksgivecreditonthebasisofpersonalgoodwillratherthanonthebasisofanyformofwealth.

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