Credit Creation

Money is a concept that is much easier to understand than to explain in the form of words. However, it can be described as an instrument or thing that is generally accepted as a mode of payment or as a Medium of Exchange in the economy, like a Rupee in India, a Dollar in the USA, or a Yen in Japan. The main motive behind the invention of Money was to eliminate the Barter System (the process of exchanging goods for acquiring goods) from the economy as it was becoming difficult to trade by exchanging goods.
 

“Anything that is accepted as a means of exchange (i.e., as a means of settling debts) and that at the same time, acts as a measure and as a store of value is called Money.” – Prof. Geoffrey Crowther
 

Money Creation or Credit Creation

The banking structure is entirely based on the creation of credit. In simple words, credit means getting the power to purchase anything now and promise to pay it later in the future; the bank charges interest in case of non-fulfillment of the desired amount. Based on these credits, the bank uses a part or a fraction of its customer deposits to offer loans or lend money on credit to other individuals and businesses.

Money creation or credit creation is one of the most important activities of commercial banks. Because of credit creation, banks are able to create credit, which is in excess of the initial deposits.

This process is based on two assumptions and can be understood with the help of them:

1.  The entire commercial banking system is considered as one unit and is termed as ‘Banks’. 
2. All receipts and payments are routed through Banks, i.e., all payments are made through cheques, and receipts are deposited in banks.

Banks use the deposits held with them for giving loans. However, they cannot use the whole deposits for lending. It is legally compulsory for the banks to maintain a certain minimum fraction of their deposits as reserves. This fraction is called Legal Reserve Ration (LRR), which is fixed by the central bank.

But why only a fraction of deposits is kept as Cash Reserve?

Banks keep only a fraction of their deposits as a Cash Reserve to maintain liquidity in the economy. The other reason why banks keep only a fraction of deposits as a Cash Reserve is because an experienced banker knows two things:

1. All the depositors do not approach the banks for withdrawal of money at the same time and all the depositors do not withdraw the entire amount in one go.
2. There is a constant flow of new deposits into the bank.

Therefore, only a fraction of the money is kept as a reserve and the rest is provided for loans to businesses and other individuals.

According to Benham, Credit Creation implies when “a bank may receive interest simply by permitting a customer to overdraw their accounts or by purchasing securities and paying for them with its cheques, thus increasing the total bank deposits.”

Some basic terms used in Credit Creation

• Primary Deposits: A deposit is considered a primary deposit when the bank accepts cash from its customer and deposits it under his name into his account. These deposits convert the currency money into deposit money.
• Secondary or Derivative Deposits: A deposit is considered a secondary or derivative deposit when the bank grants loans to the borrower. Instead of giving cash, the amount is deposited under the borrower’s name into his account.
• Excess Reserves: Every financial institution or bank is required to hold a certain amount of money as a reserve to ensure proper liquidity. However, when the cash held by the bank is above the reserve requirements set by the authority, it is said to be an excess reserve.
• Credit Multiplier: Credit Multiplier refers to the ratio of change in secondary deposits due to the change in primary deposits. 

Example

Let’s assume that the LRR (Legal Reserve Requirement) or Reserve Ratio is 20%.

• ‘A’ deposits ₹1,000 with the bank. The money deposited by ‘A’ will be the Initial Deposit. This means that the bank can keep only  ₹200 (20% of ₹2000) as cash reserve and can lend the remaining ₹800. 
• In case the bank lends ₹800 to a borrower ‘B’, the amount will not be given in the form of cash. Instead, the bank will open an account under the name of ‘B’ and the amount will be credited to his account. The money spent by ‘B’ comes back into the bank in the form of deposit accounts of those who have received this payment. This will increase the demand deposit of banks by ₹800.
• With the new deposit, the bank keeps 20% of ₹800 (i.e., ₹160) as cash revenue and lends the remaining ₹640 to another borrower ‘C’, which again comes back to the bank as a deposit when ‘C’ spends the money. This time, the demand deposit of the bank increases by ₹640.
• Further with the new deposit, the bank keeps 20% of ₹640 (i.e., ₹128) as cash reserve, and lends the remaining ₹512 to borrower ‘D’, which again comes back to the bank as a deposit when ‘D’ spends the money. This time the demand deposit of the bank increases by ₹512.
• This process of deposit creation continues till the total cash reserves become equal to the initial deposit i.e., ₹1,000.
   

Here is a tabular representation of the data:

The initial reserves of ₹800 led to the credit creation of ₹4,000, and the initial deposits of ₹1,000 with the bank led to the creation of total primary deposits of ₹5,000. 
It means that the total deposits in the bank has become five times of the initial deposit, which is the Money Multiplier.                    

Money Multiplier

Money Multiplier can be stated as the phenomenon in which the creation of money is done in the form of credit creations in the economy. In other words, a money multiplier can be described as the influence a central bank plays over the money supply by modifying the required reserve rates.

Money Multiplier or Deposit Multiplier measures the amount of money that the banks are able to create in the form of deposits with every unit of money it keeps as reserves. The Money Multiplier plays a great role in the banking system of the economy as every time the government needs to kick-start the economy, the multiplier helps decide what proportion of stimulation should be applied and in what manner.

Formula

The money multiplier is expressed as:

Where ‘r’ is the Reserve Ratio or the Cash Reserve Ratio, and it can be described as the minimum ratio required to be maintained by commercial banks.

Example 1

Calculate Money Multiplier from the given table of previous example. 

Solution

As discussed earlier, this table gives us the information that:

1. LRR or Reserve Ratio = 20%
2. Total Primary Deposits, i.e., ₹5,000
3. Total Cash Reserve, i.e., ₹1,000
4. Total Credit Creation, i.e., ₹4,000

                               = 5
Therefore, the value of Money Multiplier is 5.

Example 2

Calculate the total deposits created if initial deposits is of ₹2,000 crores and LRR is 11.5%.

Solution

Given: LRR is 11.5% or 0.115

                            = 8.69

Initial Deposits= ₹2,000

Total Deposits=Initial Deposits x Money Multiplier

                      =2,000 x 8.69

                     = ₹17,380 crores.