Credit is defined as the claim to receive payments. When a bank gives loans to people, then the bank becomes a lender and the person who takes loan from the bank is called a borrower.
When bank gives loan today it also makes arrangements to recover the same from the person in future. This means that the bank can claim the money from the borrower in future. Accordingly, the bank is able to expand its deposits. This is called credit creation by the bank. Credit is created through the act of lending and borrowing.
A bank accepts money from public as deposits. Normally these deposits are supposed to be returned back to the public if they want to withdraw them. So if all the persons, who have deposited money in the bank, withdraw their total money, then bank will be left with no money at all. But such things normally do not happen.
From common experience, it has been observed that once somebody deposits money in the bank, he or she doesn’t withdraw it at once. Mostly, people withdraw a smaller amount from their deposit whenever they require and leave the rest of the amount with the bank. To make this possible, the bank always keeps some fraction of its total deposits in the form of cash from which it keeps giving money to people who come to withdraw it. This fraction is given in percentage term.
The cash amount is kept as reserve for making cash payments to public who come to the bank to withdraw money. The fraction of the total deposit to be kept in the form of cash as cash reserve ratio. Once the bank calculates the amount to be kept as cash on the basis of cash reserve ratio, it deducts the amount from the total deposits and uses the rest of the amount to give loans to the borrowers.
With this act of the bank, the process of credit creation starts from here.
To make things simple, assume that there is only one bank in the economy. Let the banking authority has decided that the cash reserve ratio is 20%. So, the bank must keep 20% of its current deposit in the form of cash to make cash payments to persons who come to withdraw money.
Step 1: A person called A, deposits Rs.100 in the bank. As a result the bank’s deposits increases by Rs.100. As per rule the bank keeps 20% of Rs.100 as cash. So the bank keeps Rs.20 to make cash payments. So the bank can use Rs.80 to give loan.
Step 2: A person called B approaches the bank to take a loan of Rs.80. After the bank gives this loan, it can claim the amount from B in future. This means that by giving loan to person B, the bank can create another deposit of Rs.80.
Now, the total deposit with the bank is Rs.180. First, person A deposited Rs.100. By giving loan to B, the bank is able to claim Rs.80. So after two steps the bank has total deposit of Rs.180.
Step 3: Another person called C wants a loan from the bank. As per rule it has to keep 20% of Rs.80 as cash before giving further loan to anybody.
20% of Rs.80 = Rs.16. So, the bank will now keep Rs.16 as cash and give the rest of the amount as loan. So the bank can give Rs.64 as loan to C. Again by claiming this amount from C, the bank can create another deposit of Rs.64.
Continuing from the previous two steps, you can say that, after three steps the total deposits with the bank has increased up to Rs.180 + Rs.64 = Rs.244.
This chain will continue for some time. In each round, the bank keeps 20% of the increase in the deposit as cash. The bank started with an increase in its deposit by Rs.100 in step 1. So the process of credit creation (or increase in deposits) will come to an end when 20% of the deposits of each and every round taken together become Rs.100 itself.
20% of Rs.500 is Rs.100. This means that in present example, with initial increase of the bank deposit by Rs.100 and cash reserve ratio of 20%, the total credit creation will be Rs.500. Accordingly, the following formula for credit creation is:
Total Credit = Initial Increase in Deposit × 1/Cash Reserve Ratio
Rs.500 = Rs.100 × 1/20%
Since the bank deposit is divided into 20% as cash and the rest as loan through various steps, the total deposit of Rs.500 can be divided in the following manner:
Cash Reserve = 20% of Rs.500 = Rs.100
Loan Amount = Rs.500 – Rs.100 = Rs.400
In the process of credit creation two types of deposits are recorded. The first one is called Primary Deposit. Primary deposit is the initial increase in the bank deposit resulted when the bank receives a new deposit from public. In present example, primary deposit is Rs.100 deposited by person A in the beginning.
The second type of deposit is called Secondary Deposit. The deposits created due to the loans given by the bank in each round are called secondary deposits. Credit creation is possible due to the increases in the secondary deposits.
The credit creation capacity of a bank depends on the cash reserve ratio. If the cash reserve ratio is higher, then the bank has to keep more cash to make payments to public and accordingly, fewer amounts will be available for giving loans. So less credit will be created. Credit creation will be higher, if the cash reserve ratio is lower.