Credit Creation by Commercial Banks

Credit creation is the process by which the commercial banking system, taken as a whole, multiplies the community's deposits far beyond the amount of cash originally deposited with it. It is one of the most important — and, to a beginner, most surprising — functions of commercial banks, because through it the banking system, in effect, manufactures money.

The idea behind it. Experience teaches a banker that not all depositors withdraw their money at the same time. On any given day, the cash withdrawn is largely offset by fresh cash deposited, so a bank needs to keep only a fraction of its deposits as cash reserve to meet the day-to-day demand for withdrawals. The rest it can safely lend out. But here lies the key point: when a bank grants a loan, it does not usually hand over cash; it opens a deposit account in the borrower's name. Every loan, therefore, creates a new deposit — and that new deposit, when spent and re-deposited in another bank, can support yet another loan. In this way a single primary deposit ripples through the whole banking system, creating a chain of derivative deposits many times larger than the original.

Primary and derivative deposits.

• A primary deposit is the cash actually deposited by a customer.
• A derivative deposit is the deposit created by the bank when it grants a loan or buys an asset. It is the derivative deposits that represent 'created' credit.

The money multiplier. How much total deposit a given amount of cash can support depends on the fraction of deposits banks must (or choose to) keep as reserves — the cash reserve ratio (r). The total credit the system can create from a primary deposit is given by the money (credit) multiplier:

Total deposits created = Primary deposit × (1 ÷ r)

where r is the cash reserve ratio expressed as a fraction. The term (1 ÷ r) is the credit multiplier: the smaller the reserve ratio, the larger the multiplier, and the more credit the system can create.

A worked illustration. Suppose a customer deposits ₹10,000 of cash and every bank keeps a reserve ratio of 20% (r = 0.20). The first bank keeps ₹2,000 as reserve and lends ₹8,000; that ₹8,000, when spent and re-deposited in a second bank, lets the second bank keep ₹1,600 and lend ₹6,400; and so on. When the whole chain is added up, the total deposits created are ₹10,000 × (1 ÷ 0.20) = ₹50,000, of which ₹10,000 is the primary deposit and ₹40,000 is derivative (created) credit.

Limits on credit creation. The power to create credit is not unlimited. It is checked by:

• the amount of cash reserves available to the banking system;
• the cash reserve ratio fixed by the central bank (a higher ratio means less credit creation); …