credit creation by commercial bank

by Modi Hinal on Friday 24 September 2010, 10:04 PM | Category: Banking and Finance| View: 17143 views



One of the important functions of commercial bank is the creation of credit. Credit creation is the multiple expansions of banks demand deposits. It is an open secret now that banks advance a major portion of their deposits to the borrowers and keep smaller parts of deposits to the customers on demand. Even then the customers of the banks have full confidence that the depositor's lying in the banks are quite safe and can be withdrawn on demand. The banks exploit this trust of their clients and expand loans by much more time than the amount of demand deposits possessed by them. This tendency on the part of the commercial banks to expand their demand deposits as a multiple of their excess cash reserve is called creation of credit. The single bank cannot create credit. It is the banking system as a whole which can expand loans by many times of its excess cash reserves. Further, when a loan is advanced to an individuals or a business concern, it is not given in cash. The bank opens a deposit account in the name of the borrower and allows him to draw upon the bank as and when required. The loan advanced becomes the gain of deposit by some other bank. Loans thus make deposits and deposits make loans.


Credit Creation is Most Important Function of Commercial Bank, Like Other Financial Institute Bank aim to Earn Profit by Make Advance to Other. Therefore, Some Time Bank Is Called a Factory of Credit Creation. Everyone Know that People Cannot Withdrawal Money in simultaneous, some with drawl While other deposit at Same Time. So Bank Encourage Credit Creation by Given Advance to other, Keep Small Cash in Reserve se for day to day Tran sanction.


Person A Deposit in Bank Rs 10000, and Cash Reserve Ration is 10%.
Than Bank Only Keep 10% in His Account, Give 90 of Rs 10000 Amount to other By Loan Or Anything... To Person B, While Person B Deposit This Amount in His Bank, 9000, Again His Bank Keep Only 10% Reserve, And Give Remain to Person C, While This Process Will Be Cont. Until The Credit Creation is Equal to 10000.

Person          Amount         cash Reserve (10%)    Credit Creation
A                     10000           1000                                9000
B                      9000              900                                8100
C                      8100              810                       
So On....


What Does Credit Creation Mean?

Cash money is available in the form of currency notes issued by the central bank. Credit money is the amount agreed upon to pay later. It is issued by commercial banks and takes the form of cheques. Cash deposit and cash reserve requirements play an important role in the expansion and contraction of credit money. Credit expansion takes places by means of using cheques. Now suppose, person deposits rupees. 1000/= with a bank, ten percent of which will go to the central bank as cash reserve requirements. Hence the commercial bank is left with rupees.900 to be used for advancing loans. The party A that borrows this rupees.900 will either buy goods from or make payment to the other party B. The party B will receive the cheque for rupees. 900 and deposit it in the account with the same commercial bank. Now the bank receives the deposit of rupess.900. Ten percent of this amount will as usual go to the central bank and the rest of the amount will be utilized in advancing loans. Bank of England is the best example. Bank organized under cooperative societies are called cooperative banks. They work on mutual cooperation of the members.












    Ch.3:- Commercial Bank offer Wild Range Of Financial


Commercial banks offer a wide range of corporate financial services that address the specific needs of private enterprise. They provide deposit, loan and trading facilities but will not service investment activities in financial markets.

Commercial banks can be described as a type of financial intermediary. In the US, the term is used to refer to any banking organization or division that deals with the deposits and loans of business organizations.

The term commercial bank is used to differentiate these banks from investment banks, which are primarily engaged in the financial markets. Commercial banks are also differentiated from retail banks that cater to individual clients only. In non English-speaking countries the term commercial bank is used interchangeably with the term trading bank.

Commercial banks play a number of roles in the financial stability and cash flow of a countries private sector. They process payments through a variety of means including telegraphic transfer, internet banking and electronic funds transfers. Commercial banks issue bank checks and drafts, as well as accept money on term deposits.

Commercial banks also act as moneylenders, by way of installment loans and overdrafts. Loan options include secured loans, unsecured loans, and mortgage loans. A secured loan is one where the borrower provides a certain property or asset as collateral against the loan. The main condition of these loans is that if the loan remains unpaid, the bank has the right to use the property in any way they like to realize the outstanding amount. Unsecured loans have no collateral and therefore command higher interest rates. There are a variety of unsecured loans available today and these include credit cars, credit facilities such as a lines of credit, corporate bonds, and bank overdrafts.

Mortgage loans that are provided by commercial banks are similar to secured loans but are used specifically to buy real estate property for commercial purposes. In most of these cases, the banks hold a lien on the title to the particular property purchased with the loan. If the borrower is unable to pay the loan back, the bank leverages this item against the loan to generate funds or recover the principal.

Commercial banks provide a number of import financial and trading documents such as letters of credit, performance bonds, standby letters of credit, security underwriting commitments and various other types of balance sheet guarantees. They also take responsibility for safeguarding such documents and other valuables by providing safe deposit boxes.

Currency exchange functions and the provision of unit trusts and commercial insurance are typically provided by the relevant departments in larger commercial banks.

Money banking and financial market refers to the recently developed financial structure of most economies. Money in simple terms refers to a medium that is used to exchange goods and services. But circulation of money is controlled by banks performing money banking and financial markets. Money banking and financial market is a crucial part of the present economic system.

money2_m[1]     2.1 Money banking and financial market: an overview


 Money consists of paper money, coins and bank                         deposits. Nowadays credit cards and electronic cash have become an integral part of the payment system.

Uses of money:

Money refers to the notes and coins that act as a means of transaction and accounts for debits and credits. Buying and selling would be impossible without it. Generally the worth of a commodity is decided by the amount of money one has to pay for it but this doesn't imply that the real value of a good is the same as its monetary cost. This principle was popularized as the 'paradox of value' by famous economist Adam Smith. Water is essential for life but is free of cost whereas diamonds have little use but command high prices. Smith pointed out that scarcity is a more important determinant of price than utility. Thus money replaced the barter system as it is the most liquid asset available in the market as it is easily traded and has low transaction costs.

Money is also a store of value. Money can be reliably saved, stored and recovered. The notes and coins have no relevance except that they aid exchange. Money can't earn interest on itself unless invested somewhere. Money can be looked upon as an efficient store of value as it is durable and does not perish easily, imitation and creation of fake money is very difficult and the actual form of money can be easily recognized. The value of money remains almost stable over years. Variation in its value is possible but is usually negligible.

Money is the most accepted and standard unit of account for measure of relative worth of goods and for clearing deferred payments. It is possible to assume money as a reliable unit of account as it is available in smaller denominations and the value of the material used for making it is less than its face value.
Creation of money:

Money (currency) is issued primarily by the central bank of a country, the premier body bestowed with the responsibility of currency management. Commercial banks of a country also play an important role in the creation of money and the process is extremely simple.

A bank has a number of depositors who deposit money in the bank. The total money the bank has in its accounts is known has liquid assets. When the bank grants loan to a person, an account is created in his name and it is debited by the amount of loan. The bank counts the amount as its assets. The amounts in the depositor's accounts are however not disturbed. In this process the bank's obligations increase by double the amount of the loan granted. This is because the borrower can default and the depositors may ask for their money. The loan is spent by the borrower to meet his needs and thus the depositor's money now gets transformed into 'new money' in the economy. This new money then circulates through the economy. Some people also put part of this money into their deposits which is again lent out and so on. Thus a huge proportion of the money in circulation and those in deposits was actually created through loans granted by banks. Thus commercial banks have a great role in inputing huge sums of money into the economy.


     2.2  Money Supply:

Money supply is basically the amount of money that circulates in the economy at any point of time. It includes paper currency, coins and checking accounts. There are basically three definitions of money supply:

M1 money supply-

This is the most primitive definition of money supply. It says that money supply consists of cash held by the public, regular demand deposits and checking account balances and balances in NOW (Negotiable Order of Withdrawal) accounts and credit unions.

M2 money supply-

 This includes all those sources included in M1 and in addition includes saving deposits and small time deposits. Besides it also includes non-institutional money market accounts and repos (of maturity greater than one day) conducted at banks.

M3 money supply-

 This includes all sources covered by M2 and also takes into consideration large time deposits, institutional money markets and repos that are not included in M2. M3 is the broadest definition of money.

Money Supply is crucial for an economy because:

Money finances all transactions thus enhancing economic activity. The increased availability of money (due to the constant flow from central banks) circulates through the economy in a cycle. The extra money goes into the hands of consumers thus increasing their purchasing power and compelling businesses to utilize their idle capacity to meet the wants. Producers hire more people and capital and thus induce additional purchasing power in the economy. Such a bright future in turn boosts stock prices and help firms raise money using debt and equity.

But increasing money supply can have adverse impact on the economy when industrial production touches its ceiling. Under such circumstances excess demand leads to inflation and thus erodes the real value of money. This is the famous 'quantity theory of money' by Friedman. Lenders start charging a higher rate of interest as inflation reaches a substantial level. An inflationary situation leads to future expectations of price rise thus increasing present demand and an undesirable situation culminating into hoarding and black marketing. So maintaining a decent growth in money supply is imperative.

     2.3   Balancing the money supply:

Federal reserve policy dictates the fraction of deposits of commercial bank that has to be kept as reserves in cash at their vault or as deposits with the central bank. The federal reserve also performs open market operations to manipulate reserves. The federal reserve thus has the power to control both currency and bank reserves. The Federal Reserve uses both techniques-borrowed and unborrowed reserves to finely achieve the optimal growth in money supply. The interest rate mechanism and the price adjustment also help to achieve the desired growth in money supply.

Amount of money in an economy may increase or decrease. There is a boom when there is abundance of money and a slump is caused by scarcity.


In simple terms a bank is a type of financial institution that accepts deposits and makes loans. Deposits in bank are the most essential form of money in any economy. People tend to save in a bank in different forms. Some of the accounts that are most common include savings accounts, checking accounts, bank money market deposit accounts(MMDA), CD(certificates of deposits), and IRA(Individual Retirement Account). The chief sources from which a bank derives money are checks, drafts etc deposited in the bank. This money is credit to the account of the holder but is ultimately held by the bank Following are the most common accounts available in most bank:

419CERTIFICATE OF DEPOSITCertificates of Deposits-

 Banks provide their customers with a special type of deposit account known as CD which pays interest that is higher than even a savings account. CDs are insured by federal deposit upto $100,000. A CD gives an opportunity for investing an amount for a fixed period of time of 6months, 1year, 5year etc. at the time of maturity the bank returns the principal as well an interest that has accrued over time. In case of redemption before maturity, the bank usually deducts a portion of the interest rate that the CD has earned. This is widely known as 'early withdrawal' fee. In recent years there has been a reform in the market for CDs. CDs nowadays feature variable rates, call options and special redemption features in case of death of the investor. Individual and institutional CDs start from $100 and $100,000 respectively.


Savings Accounts-

piggy-bank-savings-2-252x300 Savings accounts are insured by FDIC(Federal Deposit Insurance Corporation). These promote saving out of present consumption for using in some future period. The saver can expect a higher income at some later period as the savings accounts are subject to rate of interest. He can withdraw a limited portion of his saving at times using ATMs and checks. The concept of saving accounts for kids has also been introduced so as to inculcate saving habits in children. Money deposited in the savings account is the primary source of money in most banks.

 Checking Accounts-

This account has both its pros and cons over savings accounts. A checking account holder has the facility of unlimited withdrawals using checks, ATM or transfers. However checking accounts usually don't pay any interest. Thus depositing money is almost similar to holding money idle. Some banks pay interest for deposits in checking accounts but the interest rate is just enough to compensate for the transaction costs. A monthly service fee is deducted in case the balance comes down a predetermined level. Checking accounts are usually NOW (Negotiable Order of Withdrawal) accounts thus making the customer eligible for a VISA Check Card.




The outflow of money from bank- the Efflux

Loans are made by an organization or a person (a lender) to another person or organization (borrower). It's the obligation of the borrower to repay the loan and interest accrued in installments or as a whole during or after the term of the loan. Money deposited in the bank by depositor's flows out to those who need it most as their penury doesn't allow them to fulfill their desires. The process of lending, borrowing and repaying is based on the terms and conditions laid down by the lenders. The bank bears the whole risk and has to credit the depositor's account from its own funds. So the bank keeps the asset of the borrower as collateral.


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