Credit Creation by Commercial Banks

One of the most distinctive things a commercial bank does is create credit far beyond the actual cash it holds. This is not a trick or an accounting illusion — it follows directly from the fact that a bank is required to keep only a fraction of its deposits as cash reserve, and is free to lend out the rest.

Suppose a bank receives a fresh deposit of ₹1,00,000 and, following prudent banking practice and regulatory requirement, keeps only 10% of it, that is ₹10,000, as cash reserve, lending out the remaining ₹90,000 to a borrower. That borrower typically does not keep the borrowed money as cash either — they spend it, and the person they pay deposits that ₹90,000 into their own bank account, perhaps in the same bank or a different one. That bank, in turn, keeps 10% of this new deposit as reserve and lends out the remaining 90%, and the cycle repeats: each successive deposit is a little smaller than the one before it, but together they add up to a total volume of deposits and loans in the banking system that is a multiple of the original ₹1,00,000 deposit.

This process, by which an initial deposit expands into a much larger volume of total deposits across the banking system through repeated rounds of lending and re-depositing, is called credit creation. In simple terms, credit creation means that the banking system as a whole can create more purchasing power than the actual amount of cash originally deposited into it, because every rupee lent tends to come back into the system as a fresh deposit somewhere, ready to be lent out again. …