Commerce · Ch 5 — Banking Services
Credit Creation by Commercial Banks
Credit Creation by Commercial Banks
One of the most distinctive things a commercial bank does is create credit far beyond the cash it actually holds. This follows directly from the fact that a bank is required to keep only a fraction of each deposit as a cash reserve, and is free to lend out the rest.
Suppose a bank receives a fresh deposit of ₹1,00,000 and, following the prescribed cash reserve ratio (CRR) of 10%, keeps ₹10,000 as reserve and lends out the remaining ₹90,000. The borrower spends this money, and whoever receives it deposits it into their own bank account — perhaps at the same bank or a different one. That bank again keeps 10% as reserve and lends out the rest, and the cycle continues, each round a little smaller than the last:
| Round | New deposit (₹) | Reserve kept @10% (₹) | Amount re-lent (₹) |
|---|---|---|---|
| 1 | 1,00,000 | 10,000 | 90,000 |
| 2 | 90,000 | 9,000 | 81,000 |
| 3 | 81,000 | 8,100 | 72,900 |
| ... | ... | ... | ... |
Added across every round, this geometric series converges to a total volume of deposits equal to the original deposit multiplied by 1 ÷ CRR — here, ₹1,00,000 × (1 ÷ 0.10) = ₹10,00,000. This process, by which an initial deposit expands into a much larger volume of deposits and credit across the banking system through repeated rounds of lending and re-depositing, is called credit creation. …
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