Credit Creation by Commercial Banks

Commercial banks do not keep the entire amount of a deposit idle in their vaults. Under the fractional reserve system, a bank keeps only a fraction of every deposit as a reserve (the Legal Reserve Ratio, LRR, fixed by the RBI) and lends out the rest. Because every rupee lent eventually comes back into the banking system as a fresh deposit — in the same bank or another — the banking system as a whole is able to create total deposits (and hence credit) that are a multiple of the original, or primary, deposit. This multiple is called the credit multiplier (or money multiplier):

and the total credit (total deposits) the banking system can create out of an initial deposit $D$ is:

Primary deposit vs derivative deposit

• A primary deposit is the original cash deposit made by a customer.
• A derivative deposit is a deposit created when a bank lends out part of a primary deposit and the borrower (or the person the borrower pays) redeposits it in the banking system.

The process, round by round

Suppose the LRR is 25% and Bank A receives a fresh primary deposit of ₹8,000.

The deposits keep shrinking geometrically (each round is 75% of the previous one, since 1 − LRR = 0.75) and the process continues until the additional deposit becomes negligible. Adding the whole geometric series gives exactly the same answer as the direct formula — this is the two independent checks a student should always run on a credit-creation question (see Worked Example 1 for both methods side by side).

Limitations on credit creation

In practice the credit multiplier is never fully realised because of: …