According to Reynold:

“Bank is the factory of creating 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 part of deposits for payment to the customers on demand. Even then the customers of the banks have full confidence that the deposits lying in the banks are quite safe and can be withdrawn on demand. The banks exploit the trust of their clients and expand loans by much more time than the amount of demand deposits possessed by them. So, the tendency on the part of the commercial banks to expand their demand deposits as a multiple of their excess cash reserves is called creation of credit.

According to Prof. Crowther:

“The important work of bank is to provide easy medium of exchange for the payment and receipt to people. Banks are considered as manufacturer of credit. It means they are not only the dealer of money but in actual meaning they are the creator of credit”.

WAYS OF CREDIT CREATION

The single bank cannot create credit. It is the banking system as a whole, which can expand loans many times of its excess cash reserves. Commercial banks can create credit in following three ways:

By Discounting of Bills

By Supply of Loans

By Making Investments

1. By Discounting of Bills:

A bank also creates credit through discounting of bills of exchange. In this method the bank discounts the bill and issues a cheque book after the opening of account for the amount of discounted bill instead of giving cash.

2. By Supply of Loans:

When a bank agrees to grant loan to a borrower against the securities then it opens an account of the borrower for the granted amount of loan instead of giving cash. If the borrower wants to make payment to another person then it issues the cheque, which is deposited by the receiver into another bank. In this way the process of credit creation goes on.

3. By Making Investments:

A bank also creates credit by making investment in securities. It buys securities from stock exchange and then credits the amount in the account of the seller or it pays a crossed cheque to the seller, which he can collect by depositing it into his bank account.

PROCESS OF CREDIT CREATION

For the explanation purpose we have to take the following assumptions:

1. Primary (new) Deposit Rs. 2000.
2. All the payments and receipts are made through banks or cheques.
3. There is no leakage in the credit creation.
4. The central bank does not adopt any credit control policy.
5. Ratio of cash reserve is 20%, which remains constant through all the stages of the credit creation process.

Ways OF Credit Creation In Bank: Understanding the Process

Introduction

Credit creation is a fundamental process in the banking sector that plays a significant role in the economy. When a bank grants a loan or extends credit to a customer, it creates new money that goes into circulation. This article will explore the various ways in which credit creation takes place in banks, shedding light on the mechanisms behind this crucial process.

Understanding Credit Creation

To grasp how credit creation works, it is vital to comprehend the concept of fractional-reserve banking. Under this system, banks are required to hold only a fraction of their deposits in reserves, allowing them to lend out the remaining portion. This lending process is what initiates credit creation.

Step 1: Customer Deposits

The credit creation process begins when a customer deposits money into a bank account. Let’s say a customer, John, deposits $10,000 into his account.

Step 2: Reserve Requirement

Before a bank can lend out funds, it needs to comply with the reserve requirements set by the central bank. These requirements determine the minimum amount of reserves a bank must keep on hand.

Step 3: Credit Creation

Once the bank meets its reserve requirements, it can proceed to create credit. In John’s case, the bank can now lend out a portion of the $10,000 deposit, let’s say $8,000, while keeping $2,000 as reserves.

Step 4: New Money Enters Circulation

When the bank extends credit to another borrower, such as Mary, the $8,000 loan is deposited into her account. Mary now has access to this newly created money, which increases the overall money supply in circulation.

Step 5: Repeat the Process

The cycle continues as Mary deposits the $8,000 into her account, allowing the bank to create credit once again. This process repeats itself, enabling banks to create credit multiple times using the initial deposit.

Impact on the Economy

The credit creation process has a profound impact on the economy. As banks continue to lend out funds and create credit, it promotes economic growth and stimulates spending. This, in turn, increases business activity and creates employment opportunities.

Risks and Regulations

While credit creation is essential for the economy, it also carries certain risks. Excessive credit creation can lead to inflation and economic instability. To mitigate these risks, central banks regulate the credit creation process by setting reserve requirements and interest rates.

Example: Illustrating the Credit Creation Process

Let’s look at a concrete example to better understand the credit creation process. Suppose Bank XYZ has a reserve requirement of 10% on all deposits.

1. John deposits $10,000 into his account at Bank XYZ. The bank now has $10,000 in reserves.
2. Bank XYZ can lend out $9,000 (90% of the deposit) as credit while keeping $1,000 in reserves.
3. Mary borrows the $9,000, which is deposited into her account. Now, Mary has access to the newly created money.
4. Bank XYZ can once again use a portion of Mary’s deposit as reserves and lend out the remaining amount, further expanding credit creation.
   This process continues, creating a multiplier effect as each new loan generates more deposits. It demonstrates how a relatively small initial deposit can lead to a significant increase in credit and money supply within the economy.

Conclusion

Credit creation is a vital process in the banking sector that helps drive economic growth and development. By understanding the steps involved in credit creation, we gain insight into how banks play a crucial role in expanding the money supply. As banks carefully manage credit creation while adhering to regulations, they contribute to the stability and progress of the economy.