Credit Creation By Commercial Banks and the Limitations

In the Article we will cover the basic of credit creation by Commercial Banks and how the central bank attempts to reduce it, i.e is it’s limitations, This topic  is often ask in the gce , gcse and it the gce A level.

Credit Creation By Commercial Banks

Credit creation refers to the process where by banks expand their lending on the basic of deposits they receive . credit creation begins with deposits of cash.(ie bank notes and coins) by a customer; part of these deposits is given out as loans or is used by the banks to buy securities. Banks make their profits from loans. Banks also know that not all customers who have deposited their profits from loans. Banks also know that not all customers who have deposited their money would come at the same time to withdraw the money.

They also know that as some customers are withdrawing each from the banks others are depositing cash. The bank therefore have cash in their tills(safe). They therefore keep a reserve of cash and give the remaining cash out as loans, since interest on loans from the main source of profit to the bank. In a situation where cheques are used the money.

It’s self doesn’t leave the banking system. The use of cheques loads only to increases and decreases in customers account without the cash it’s self being touched. The process of credit creation can be explained by the following examples suppose the customer of a bank, Mr. A, deposits cash of 100, 000frs, this amount is recorded on his credit side of his bank account.

Credit Creation By Commercial Banks and the Limitations

His account is therefore said to be credited.

The bank keeps a cash ratio of 20% (i.e the banks keeps 20 .000francs FCFA) and gives 80 FRS CFA) and loan to Mr. B. this amount is recorded on the credit side is recorded on the credit side of Mr. B account to enable him use the money. This implies that another credit has been created.

If Mr. B buys goods for 80 000frs from Mr. C and pays him by cheques. The money (80.000frs) finds itself back in the banking system as a deposit of 80 000frs in Mr. C’s account. The bank can then keep 20 %( 16000 FRS) and give the remaining 64000 FRS as loan and the process continues.

Credit creation can only take place in a situation where there is only a single bank or where all the banks work together.

Limitations of Credit Creation By Commercial Banks

Commercial banks may not be able to create as much credit as they wish, this is because their ability to create credit is limited by several factors. This factors include.

1) Increase in the cash ratio
The commercial banks have to keep a certain proportion of deposits in cash. This is called the cash ratio. The banks ability to create credit is limited by the cash ratio where the cash ratio is raised leading and credit creation are very much limited.

2) Limited amount of money in circulation
The amount of deposits depends on the amount of money in circulation where the amount of money is small, the amount of deposits would be small and credit creation would be limited.

3) Increased desire of the public to bold money
The people prefer to hold money instead of investing it or putting these amount of money in the bank. It would reduce the amount of deposits and credit creation.

4) In availability of acceptable collateral securities
Banks lend out money to customers on conditions that these customers have acceptable collateral securities. If the customers do not have the required collateral securities. Commercial banks would reduce lending which would also reduce credit creation.

5) Withdrawal of cash from the banking system.
Credit creation depends very much on the use of cheques where customers of a bank prefer to withdraw cash instead of using cheques credit creation would be limited. This is because the banks would limit lending so that more cash is not redrawn from the banking system.

6) Contractionary monetary policies.
In order to reduce credit creation, the central bank would use these monetary policies that would reduce the money supply and there by reduce credit creation.

7) Limitations associated with clearing of cheques
Each commercial bank maintains a deposit with central bank which is used to settle indebtedness during clearing of cheques. If a bank engages in more credit creation that other banks. It would suffer a persistent drain in its deposits and this compels banks to limit credit creation.