Page 65 - DCOM208_BANKING_THEORY_AND_PRACTICE

Banking Theory and Practice

Notes It means that the banking system can create credit together which is ten times more than the
original increase in the deposits. It should be noted here that the size of credit multiplier is
inversely related to the percentage of cash reserves the banks have to maintain.

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Caution If the reserve ratio increases, the size of credit multiplier is reduced and if the
reserve ratio is reduced, the size of credit multiplier will increase.

Self Assessment

Fill in the blanks:
8. Banks cannot lend the entire primary deposits as they are required to maintain a certain
proportion of primary deposits in the form of …………………….. with the RBI under RBI
& Banking Regulation Act.
9. The banking system as a whole can create ………………… which is several times more
than the original increase in the deposits of a bank.

4.3 Limitation of Credit Creation

Though commercial banks have the power to create credit, they possess limited powers. Certain
factors affect the process of credit creation. They are termed as limitations to credit creation by
commercial banks.
The limitations of credit creation by commercial banks are as follows:

Amount of Deposit: The most significant factor which determines credit creation is the
amount of deposits made by the depositors. Higher is the amount of deposits; greater is
the supply of credit and vice versa.
Cash Reserve Ratio (CRR): There exists an indirect relationship between Credit Creation
and Cash Reserve Ratio. Higher is the Cash Reserve Ratio more will be the reserves to be
maintained and less credit will be created by banks. The CRR is fixed by the RBI in India.
It ranges from 3% to 15%.

Banking Habits of People: If the banking habits of the people are well-developed, then all
of their transactions would be through banks, and this will lead to expansion of credit and
vice-versa.
Supply of Securities: Loans are sanctioned on the basis of the securities provided to the
banks. If securities are available then the credit creation will be more and vice-versa.
Willingness of people to borrow: Commercial banks may have enough money to lend.
Customers should be willing to borrow from the banks to facilitate credit creation. If they
are willing to borrow, then the credit created by banks will be less.
Monetary Policy of Central Bank: While credit is created by commercial banks, it is
controlled by the Central Bank. Credit control is one important function of the central
bank. Central Bank uses various methods of Credit Control from time to time and thus
influences the banks to expand or contract credit.
External Drain: External Drain refers to withdrawal of cash from the banking system by
the public. It lowers the reserves of the banks and limits the credit creation.

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