Page 60 - DCOM208_BANKING_THEORY_AND_PRACTICE

Unit 4: Credit Creation

According to Benhen, “A bank may receive interest simply by permitting a customer to overdraw their Notes
account or by purchasing securities and having for them with its own cheques. Thus, increasing the total
bank drafts. One should remember that single bank creates a very little credit. It is a whole banking system
which can expand the credit.”
Secondly when loans are advanced, it is not given in cash. The bank opens a deposit account in
the name of the borrower and allows him to withdraw whenever required.

Notes The loans that are advanced by cheques results in the creation of new demand
deposits.
Sometimes, a question arises that if the borrower withdraws these deposits for the repayment to
other individual, then how will credit be created by the banks. The answer is that other individuals
who receive money may also be the clients of the bank. Naturally they will also deposit their
cash in the same bank. This process keeps on repeating itself. It can be better explained by the
following example:

Example: Suppose a person deposits 1,000 in a bank. According to experience bank can
keep 20% cash reserve to meet the demands of the depositors, and can lend the rest safely to the
borrowers. If the entire bank maintains a reserve ratio of 20% then banks can succeed in creating
a credit a credit of ` 5000 against an original deposit of ` 1,000 in cash.

Task Visit a commercial bank and enquire a high level bank personnel about the process
of credit creation.

4.1.1 Basis of Credit Creation

Bank deposit is the basis for credit money. The bank deposits are of two kinds’ viz., (1) Primary
deposits, and (2) Derivative deposits.
1. Primary Deposits: Primary deposits arise or spring up when cash or cheque is deposited
by customers. When a person deposits cash or cheque, the bank will credit his account. The
customer is free to withdraw the amount whenever he wants through cheque. These
deposits are called “primary deposits” or “cash deposits.” It is out of these primary deposits
that the banks provide loans and advances to its customers. The initiative is taken by the
customers themselves. In this case, bank plays a passive role. So, these deposits are also
called “passive deposits.” These deposits merely convert currency money into deposit
money. They do not create money. They do not make any net addition to the stock of
money. In other words, there is no increase in the supply of money.

2. Derivative Deposits: Bank deposits also arise when a loan is granted or when a bank
discounts a bill or purchase government securities. Deposits which arise on account of
granting loan or purchase of assets by a bank are called “derivative deposits.” Since the
bank play an active role in the creation of such deposits, they are also known as “active
deposits.” When the banker sanctions a loan to a customer, a deposit account is opened in
the name of the customer and the sum is credited to his account. No cash is paid by the
bank to the banker for doing so. Customer is free to withdraw the amount whenever he
require by the medium of cheque. Thus, the banker lends money in the form of deposit

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