Page 63 - DCOM208_BANKING_THEORY_AND_PRACTICE

Banking Theory and Practice

Notes 6. When a person deposits money or cheque, the bank will ………………….. his account.
7. Deposits which arise on account of granting loan or purchase of assets by a bank are called
“………………………………..”

4.2 Process of Credit Creation

The process of ‘Credit Creation’ begins when money is lent by banks out of primary deposits. In
fact banks cannot lend the entire primary deposits as they are required to maintain a certain
proportion of primary deposits in the form of reserves with the RBI under RBI & Banking
Regulation Act. After maintaining the required reserves, the bank can lend the remaining portion
of primary deposits. Here banks lend the money and there the process of credit creation starts.
A significant aspect of the credit creating function of the commercial banks is the process of
multiple-expansion of credit.

Did u know? The banking system as a whole can create credit which is several times more
than the original increase in the deposits of a bank. This process is called the multiple-
expansion or multiple-creation of credit.

Similarly, if there is withdrawal from any one bank, it leads to the process of multiple-contraction
of credit. The process of multiple credit-expansions can be illustrated by assuming:
(a) The existence of a number of banks, A, B, C etc., each with different sets of depositors,

(b) Every bank has to keep 10% of cash reserves, according to law, and
(c) A new deposit of ` 1,000 has been made with bank A to start with.
Suppose, a person deposits ` 1,000 cash in Bank A. As a result, the deposits of bank A increase by
` 1,000 and cash also increases by ` 1,000. The balance sheet of the bank is as follows:
Balance Sheet of Bank A
Liabilities ` Assets `
New deposit 1,000 New Cash 1,000
Total 1,000 1,000
Under the double entry system, the amount of ` 1,000 is shown on both sides. The deposit of `
1,000 is a liability for the bank and it is also an asset to the bank. Bank A has to keep only 10%
cash reserve, i.e., ` 100 against its new deposit and it has a surplus of ` 900 which it can profitably
utilize in the assets like loans. Suppose bank A gives a loan to X, who uses the amount to pay off
his creditors. After the loan has been made and the amount so withdrawn by X to pay off his
creditors, the balance sheet of bank A will be as follows:
Balance Sheet of Bank A
Liabilities ` Assets `
Deposit 1,000 New Cash 100
Loan to X 900
Total 1,000 1,000

Suppose X purchase goods of the value of ` 900 from Y and pay cash. Y deposits the amount with
Bank B. The deposits of Bank B now increase by ` 900 and its cash also increases by ` 900. After

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