Introduction

In this article you will learn about " Credit Creation By Commercial Bank "in simple language and you will be able to understand it. But first of all you should know the meaning and concept of Credit Creation and Commercial Bank because it will help you in understanding the further topics clearly. 

Commercial Bank

Commercial Bank is primary unit of the Indian Banking System. Like other businesses, commercial banks also aim to earn profits and for the, they offer variety of services to their customers. Commercial Bank is an institution which performs the functions of accepting deposits, granting loans and making investments, with the aim of earning profits. State Bank of India (SBI) , Punjab National Bank (PNB), Allahabad Bank, Canara Bank are some examples of Commercial Banks Of India. Commercial banks act as financial intermediaries whose main function is to collect savings from the household sector and lend it to the productive sector. 

Meaning Of Credit Creation

 Credit creation is the process by which commercial banks are able to create credit/money in the form of new deposits. In this process commercial banks uses a part of deposits of its customers to offer loans to other people and businesses. By expanding their deposits, commercial  banks create credit in an economy. Commercial banks do this by way of loans of primary deposits (cash deposits of the people with the commercial banks) many times. 





Credit Creation Or Money Creation By Commercial Banks 

It is the one of the most important activities of commercial banks. Through the process of money creation/ credit creation, commercial banks are able to create credit, which is in far excess of the Primary Deposits. Primary deposits are the cash deposits of the people with the commercial banks in different deposit account such as saving accounts, current accounts, term deposits accounts and other deposits. On the other hand, Secondary or Derivative Deposits are those deposits which are arise due to loans given by the commercial banks to the people. 

The process of credit creation can be better understand by making two assumptions :-
  1. The entire commercial banking system is one unit and is termed as 'Banks'. 
  2. All receipts and payments in the economy are routed through the Banks, i.e., all payments are made through cheques and all receipts are deposited in the banks. 
The deposits held by Banks are used for giving loans. Commercial banks grant loan to the borrower by opening a deposits account in the name of the borrower and credit the loan amount in this account. This is called secondary deposits. However, banks cannot use the whole of deposit for lending. It is legally compulsory for the banks to keep a certain minimum fraction of their deposits as reserves with the central bank that will be used for meeting the immediate cash requirements of the depositors . The fraction is called the Legal Reserve Ratio (LRR) or Reserve Deposit Ratio or Reserve Ratio (RR) and is fixed by the central bank.
 The Legal Reserve Ratio (LRR) has two components:-

1. Cash Reserve Ratio :

It is the cash reserves of commercial banks with the central bank as a percentage of their deposits. 

2. Statutory Liquidity Ratio:

It is the reserves in the form of liquid assets like cash, gold, securities with the commercial banks themselves, as a percentage of their total deposits. 

Why only fraction of deposits are kept as Cash Reserves? 

Banks keep a fraction of deposits as Cash Reserve because :-
  1. All the depositors do not approach the banks for withdrawal of money at the same time and also they do not withdraw the entire amount in one go. 
  2. There is a constant flow of new deposits into the banks. 

Frequently Asked Questions

Question 1. What is credit creation by commercial banks? 
Credit creation refers to expanding the availability of money through the advancement of loan. In this process commercial banks uses the part of deposits of its customers to offer loan to other people and businesses. 

Question 2. How credit creation is determined by commercial banks? 
The credit creation process of commercial banks is determined by the amount of initial deposits and the cash reserve ratio. 

Question 3. What are the two types of credit control? 
Quantitative control to regulates the volume of total credit and Qualitative control to regulates the flow of credit. 

Question 4. What are the advantages of credit creation by commercial banks? 
Due to credit creation process, money supply in the economy increases and this leads to growth of economy .