Creation of credit
Creation of credit is one of the most important functions of a modern bank. That is why a bank has sometimes been called a factory for the manufacture of credit.
Creation of credit
Creation of credit is one of the most important functions of a modern bank. That is why a bank has sometimes been called a factory for the manufacture of credit. -
Process of credit creation
It is an open secret that the banks do not keep cent per cent reserve against deposits in order to meet the demands of the depositors. The bank is not a cloak room where you can keep your currency notes or coins and claim those very currency notes or coins when you desire. It is generally understood that money deposited with the bank is meant to be advanced to others. A depositor has to be simply content with the bank's promise or undertaking to pay him whenever he makes a demand. This bank is able to do with a very small reserve, because the depositors do not come to withdraw money simultaneously; some withdraw, while others deposit at the same time. The bank is thus enabled to erect a vast superstructure of credit on the basis of a small cash reserve. The bank is able to lend money and charge interest without parting with cash, as the bank loan creates a deposit, or it creates credit for the borrowers.
Similarly, the bank buys securities and pays the sellers with its own cheques which again is no cash; it is just a promise to pay cash. The cheque is deposited in some bank and a deposit is created or credit has been created for the seller of the securities. This is credit creation.
From the aforesaid, it is clear that there are two ways in which a bank creates credit:
(i) By advancing loans on the cash-credit basis or by an overdraft agreement;
(ii) By purchasing securities and paying for them with its own cheques.
In both these cases, deposits are created (or credit is created for the borrower) and the credit of the bank is embodied in a definite transaction. In all, a very small cash reserve is kept by the bank to meet the obligations arising out of these transactions and the credit aggregates to a very big amount.
Let us see the actual process. Suppose, a customer deposits Rs. 1,000 in a bank. The bank has to pay him interest; therefore, the bank must seek a safe and profitable investment for this amount. It must lend it to somebody. But this amount is not actually paid out to the borrower; it is retained by the bank to meet its obligations, i.e., to pay to those of its depositors who need cash and raw cheques for this purpose. The bankers' experience tells him that for this purpose only a certain percentage of cash reserve to total liabilities need be kept. In countries like Britain, they keep nearly 7 per cent. The ratio of cash to liabilities is higher in countries like India where banking habit has yet to develop.
Suppose the bank in which a depositor has deposited Hs. 1,000 keeps 20 perent cash reserve to meet the demand of the depositors. This means that, as soon as the bank has received Rs. 1,000, it will make up its mind to advance loans up to the amount of Rs. 5,000 (only one-fifth reserve is kept). When, therefore, a business man comes to the bank with a request for a loan of Rs. 5,000, he may be sure of being granted accommodation to this extent, provided, of course, his credit is good. The bank lends Rs. 5,000 although it has only Rs. 1,000 in cash. It is here that credit comes in. This transaction is rendered possible because the borrower is not given the loan in cash; only an account is opened in his name and the amount is credited to that account. He is simply given the cheque book, i.e., the right to draw cheques as and when he needs money.
Even when he draws cash, it may be deposited in another bank, for the businessmen do not raise funds to keep them locked up in a cash box but to run their business and to make payments to their creditors. When this particular businessman draws cheques on his bank to pay his creditors, these cheques are passed on by them to their own banks where the amounts are deposited in their accounts. Cash is seldom withdrawn. The banks adjust their mutual obligations through a system of bank clearing. Thus, the bank has succeeded in creating a credit of Rs. 5,000 against a cash reserve of Rs. 1,000.
But the process of credit creation does not stop here. The banks generally keep their spare cash in the central bank. A portion of Rs. 1,000, therefore, is deposited in the central bank which in its turn uses it as a basis for similarly creating further credit. Just as the banks go on creating credit (i.e., advancing loans on cash credit) all the time relying on their cash balances with the central bank, in the same manner the branch banks go on accommodating their local customers relying on the resources of the head office. The movement of credit creation thus goes apace. This is one way of creating credit.
The second way of creating credit is very simple. The bank can purchase securities without paying any cash. It issues its own cheque to pay the purchase price. The cheque is deposited in this bank or some other bank and the small cash reserve which the bank keeps is sufficient to meet an obligation arising from this transaction too. It is thus that on a small cash foundation a vast superstructure of credit is built up.