Introduction

The creation of credit or deposits is one of the most vital operations of the commercial banks. Similar to other corporations, banks aim at earnings profits. For this intention, they accept cash in demand deposits and advance loans on credit to customers. When a bank advances funds, it does not pay the amount in currency notes. However, it introduces a current account in the name of the investor and lets him to withdraw the necessary amount by cheques. By this way, banks create deposits or credit.

Demand deposits mount in two ways:

• When the customer deposits currency with commercial banks, and
• 
  
• When banks advance loans, discount bills, provide overdraft facilities and make deposit investments through bonds and securities.

The first type of demand deposits is termed “primary deposits”. Banks play a passive play in introducing them.

The second type of demand deposits is termed as “derivative deposits”. Banks actively create deposits.

As per Withers,

Banks can generate credit by introducing a deposit, every time they advance a loan.

• This is for the reason that every time a loan is sanctioned, imbursement is made through cheques by the customers.
• 
  
• All such imbursements are regulated through the clearing house.
• 
  
• As long as the loan is due, a deposit of that amount remains pending in the books of the bank.
• 
  
• Thus every loan creates a deposit; however, this is an overstated and tremendous outlook.

Dr.Leaf and practical bankers do not agree with this outlook. As per them,

• They go to the contra intense.
• 
  
• They hold that banks cannot create money out of skinny air.
• 
  
• They can lend only what they have in cash.
• 
  
• Hence, they cannot and do not create funds.

The Progression of Credit Creation

Now let us see the real progression of credit creation.

A bank can lend parity to its surplus reserves. However, the whole banking system can lend and create credit up-till a multiple of its nominal surplus funds deposits.

The deposit multiplier is based upon the required reserve which is the foundation of credit creation.

Metaphorically, the required reserve ratio is given as:

RRr = RR

D

Or RR = RRr x D

Where RR is the required cash reserves with banks, RRr is the required reserve ratio and D is the demand deposits of banks.

To represent that D is based on RR and RRr, we have divide both sides equally by RRr like the following:

RR = RRr x D

RRr RRr

Or RR = D

RRr

Or 1 = D

RRr RR

Or D = 1 x RR

RRr

Where 1 / RRr, is the reciprocal of the percentage ratio and is termed as the deposit expansion multiplier. It ascertains the bounds of the deposit expansion of a bank.

The optimum amount of demand deposits which the banking system can support with any specified value of RR is by applying the multiplier to RR.

Taking the original variation in the amount of deposits (ΔD) and in cash reserves (ΔRR), it follows from any specified percentage of RRr.

ΔD = RR x 1

RRr

To know more, let us see a small illustration.

Illustration 53

Presume RRr for the banks is fixed at 10 percent and the initial variation in cash reserves is $ 2000.

Determine the maximum increase in demand deposits with using the above formula.

Solution:

ΔD = 2,000 x 1

0.10

= $ 20,000

This is the extent to which the banking system can create credit. The above equation can also be expressed as follows:

ΔD = RR (1 + (1-RRr) + (1-RRr)^2 + ……. + (1-RRr)^1

The sum of the arithmetic progression within bracken specified:

1 = 1

1 – (1-RRr) RRr

ΔD = ΔRR x 1

RRr

The deposit enlargement multiplier rests on the postulations that banks lend out all their surplus and RRr remains invariable.

To describe the procedure of credit creation, we make the succeeding postulations.

1. There are many banks say A, B, C etc in the banking system.
2. Each bank has to hold 10% of its deposits in reserves. In other words 10 % is the required ratio fixed by statute.
3. The first bank has $2000 as deposits.
4. The loan amount drawn by the customer of one bank is deposited in full in the second bank and that of the second bank into the third bank and so on.
5. Each bank begins with the nominal deposit which is deposited by the debtor of the other bank.