Page 59 - DCOM208_BANKING_THEORY_AND_PRACTICE

Banking Theory and Practice

Notes by one party – lender, seller, or shareholder/owner – to another party – borrower, buyer, or a
business firm. The former could be a pure lender – a financial institution or a private money
lender, a seller/supplier of goods on the promise of the buyer to make payment in future, or a
shareholder/owner of a firm making funds available to the firm recognized as a separate entity.
More commonly, the term credit is practiced in a narrow sense that is only for debt finance.
Credit is simply the opposite of debt; both are created instantly by the same contract. It is a
special sort of exchange transaction involving future payments, interest added to debt at its time
value. This view of credit lies at the heart of modern commercial banking.
The commercial banks create multiple expansions of their bank deposits and due to this, these
are called the factories of credit.

Notes The major portion of the deposits of commercial banks is given as advance to the
borrowers and the smaller one is kept by themselves.
The customers have full faith on the bank. The banks expand loans by much more than the
amount of cash possessed by them. This tendency on the part of the banks to lend more than the
amount of cash possessed by them is called creation of credit in economics. Credit creation
constitutes the major component of money supply in the economy. Commercial banks differ
from other financial institutions in this aspect. Other financial institutions transfer money from
the lenders to the borrowers.

While performing the same function, commercial banks create credit or bank money also. The
process of credit creation takes place when banks provide loans and advances and accepts deposits.
When the customer deposits money with the bank, they are called primary deposits. This money
will not be withdrawn by them immediately. Hence, banks keeps a certain amount of deposits
as reserves which is known as cash reserve ratio and provide the balance amount as loans and
advances. Thus, each and every deposit creates a loan. Commercial banks give loans and advances
against some security to the public. But the bank does not give the amount of loan directly. It
opens an account in the name of the borrower and deposits the amount in that account. Thus,
every loan creates a deposit. The loan amount can be withdrawn by means of cheques. They
create deposits while lending money as well. These deposits created by banks with the help of
primary deposits are called derivative deposits.

These loans are used by customers to make payments. While paying they issue a cheque against
these deposits. The person who receives the cheque, deposit it in another bank. For that bank,
this will be the primary deposit. A part of the deposit will be kept as a reserve and the balance
will be used for giving loans and advances. This process is repeated by other banks. When all the
banks are involved in this process, it is called Multiple Credit Creation.
Reserve Bank of India is the first source of supply of money in the form of currency in circulation.
The central bank is the only note issuing authority of the country. The RBI ensures availability
of currency to meet the transaction needs of the economy. The total volume of money in the
economy should be enough to facilitate the various types of economic activities such as production,
distribution and consumption. The commercial banks are the second most significant source of
money supply. The money supplied by commercial banks is called as the credit money.

Normally, banks create credit in two ways:
By over drafting.

By purchase of securities.

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