Page 61 - DCOM208_BANKING_THEORY_AND_PRACTICE

Banking Theory and Practice

Notes credit. The creation of a derivative deposit results in a net increase in the total supply of
money in the economy; Hartly Withers says “every loan creates a deposit.” It may also be
said “loans make deposits” or “loans create deposits.” It is rightly said that “deposits are
the children of loans, and credit is the creation of bank clerk’s pen.”
Granting a loan is not the only method of creating deposit or credit. Deposits also arise when a
bank purchase government securities or discounts a bill. When the bank buys government
securities, it does not pay the purchase price at once in cash. It simply credits the account of the
government with the purchase price. The government is free to withdraw the amount whenever
it wants by cheque. Similarly, when a bank purchase a bill of exchange or discounts a bill of
exchange, the proceeds of the bill of exchange is credited to the account of the seller and promises
to pay the amount whenever he wants. Thus, assets acquired by a bank create equivalent bank
deposits. It is perfectly correct to state that “bank loans create deposits.” The derivative deposits
are regarded as bank money or credit. Thus, the power of commercial banks to expand deposits
through loans, advances and investments is known as “credit creation.” Thus, credit creation
implies multiplication of bank deposits. Credit creation may be defined as “the expansion of
bank deposits through the process of more loans and advances and investments.”

Caselet Credit Creation by Banks

Suppose there are a number of Commercial Banks in the Banking System – Bank 1, Bank 2,
Bank 3, & So on.

To begin with let us suppose that an individual “A” makes a deposit of ` 100 in bank 1.
Bank “1” is required to maintain a Cash Reserve Requirement of 5% (Prevailing Rate)
which is decided by the RBI’s Monetary Policy from the deposits made by ‘A’. Bank “1” is
required to maintain a cash reserve of ` 5 (5% of 100). The bank has now lendable funds of
` 95(100 – 5). Let the Bank “1” lend ` 95 to a borrower; say B, the method of lending is the
same that is bank 1 opens an account in the name of the borrower cheque for the loan
amount. At the end of the process of deposits & lending, the balance sheet of bank reads as
given below:
Balance Sheet of Bank

Liabilities Amount Assets Amount
A's deposits 100 Cash Reserve 5
Loan to "B" 95
Total 100 Total 100
Now bank 2 carries out its banking transaction. It keeps a cash reserve to the extend of 5%,
that is ` 4.75 (5% of 95) and lend ` 90.5 to a borrower D. at the end of the process the balance
sheet of Bank 2 will be look like:
Balance Sheet of Bank

Liabilities Amount Assets Amount
B's deposits 95 Cash Reserve 4.75
Loan to "C" 90.5
Total 95 Total 95

Contd...

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