CREATION OF CREDIT
Creation of credit is onc of the most important functions of a modern bank. A hank has sometimes been called a factory for the manufacture ofcredit. Let us see what we mean by credit creation. how it is created by the banks and, finally, whether the
power ofthe banks to create credit is absolute and serve to total liabilities need be kept In countries like England, they keep nearly 10 per cent. The ratio ufcash to liabilities is much higher in countries like India, where banking habit has nut yet fully developed.
Suppose the bank, in which a depositor has depositedRs. 1,000, keeps 20 per cent cash reserve to mect the demands of depositors. This means that as soon as the bank has received Rs. 1.000, it will make p its mind to advance loans up to the amount of Rs. 5,000 (only one-fifth reserve is kepI). Whcn. therefore, a businessman comes to the bank with ~ request for a loan of Rs. 5,000, he ‘may be sure of being granted accouuuodation to this extent. provided, of course, his credit is good. The hank would have liabilities of Rs. S,OOO,although it has only Rs. 1.000 in cash. It is here ‘that credit in.This transaction is rendered possible. because the borrower is not given the loan in cash; only an account s opened in his name and/or the amount is credited to that account. He is simply given a cheque book. i.e., the right to draw cheques as and when he needs money. Even when he withdraws cash, it may 00 deposited in another bank, for businessmen do not raise funds to keep them locked up in a cash OOX but to run their business and to make payments to their creditors.When this particular businessman draws cheques on this bank to pay his creditors, these cheques are passed on by them to their own banks, where the
amount is deposited in their accounts. Cash is seldom withdrawn. The banks settle heir mutual obligations through a system of bank clearing. Thus, the bank has succeeded in creating a credit of Rs. 5,000 against a cash reserve of Rs. 1,000. But e process of credit creation does not stop here. The banks generally keep their pare cash into the central bank. A portion of Rs. 1,000, therefore, is deposited in the entral bank which in its turn uses it as a basis for similarly creating further credit.
Just as the banks go on creating credit (i.e., advancing loans on cash credit) all the ti1ne relying on their cash balances with the central bank, in the same manner the branch banks go on accommodating their local customers relying on the resources of the head office. he movement of credit creation thus goes apace. This is one way of creating credit. The second way of creating credit is very simple. The bank can purchase securities without paying any cash. It issues its own cheque to pay the purchase price. The cheque is deposited in this bank or some other bank and the small cash reserve which the bank keeps is sufficient to meet the obligation arising from this transaction too. From the account of credit creation given above, it would seem that “the banks real’ where they have 1i0 Town.’ They advance loans or buy securities without actually paying cash. But they earn interest on the loans they give or earn dividends on ihe securities they purchase all the same. This is very tempting. They make profits without investing cash. They would, of course, like to make as much profits like this as they can. But they cannot go on expanding credit indefinitely. In their own interest, they have to apply the brake,md they do actually apply it, for it is well known that the profits made by the banks are 1I0t very high. I’he overriding limitation arises from the ohligalillll of the banks ‘The demands of their dcpu-irors. Benham has mentioned three limitations un the powers of the banks to create credi.
(i) The total amount of cash in the country;
(ii) The amount of cash which the public wishes to hold, i.e., the ratio in which ‘the public wishes to hold bank notes and bank deposits .
(iii) The minimum percentage of cash to deposits which the banks consider safe, i.e., the reserve ratio.
As for (i) it may be said that credit can be created – only on the basis of cash. The larger the cash (i.e., legal tender money) the larger-the amount of creditthat can be created assuming no change in (ii). But the amount of cash that a bank may have is subject to the control of the central,bank or it depends on the monetary policy of the Central bank. We shall study this influences in full in the next chapter. Here it may suffice to say that the central bank has the monopoly of issue of ca •. It may increase it or decrease it, and credit will elpand or contract accordingly. The Central
bank can also influence the amount of cash in the country through open market operations (to be discussed later). It can increase cash with the conunercial banks by purchasing securities and reduce it by selling securities. Thus, the power of the central bank to control currency is the controlling influence on the extent of credit that the banks can create. The second limitation arises from the habit of thepeople regarding the use of cash. If people are in the habit of using cash and not cheques, as in India, then as soon as credit is sanctioned by the bank to a borrower, he will draw a cheque and get cash. When the bank’s cash reserve is thus reduced, its power to ate credit is correspondingly reduced. On the other hand, if people use cash only for very small and odd transactions, then the cash reserve of the banks is not much drawn upon, and their power of creating credit remains unimpaired. This is the case in advanced countries like the U.S.A., the U.K. and other European countries. There the banks hardly keep 10 per cent cash reserve.
the traditional reserve ratio of cash to liabilities, which the banks must maintain to ensure their safety and to retain the degree of liquidity that is considered desirable. It is clear that when a bank creates a credit or sanctions a loan, it undertakes a liability. There is an increase in its liabilities and there is correspondingly a fall in the reserve ratio. The bank will not let the ratio fall below a certain minimum. When that minimum is reached, the power of the bank to create further credit comes to an end. To grant any further credit will be risky unless the bank’s experience is r eassuring enough to per it the adoption of a lowerca h ratio. Then that would be the limit. To these may be added the fourth limitation. The bank cannot create credit without acquiring assets (in this case the borrower’s promise to pay on some security). An asset is a form of wealth. Thus, the bank only turns wealth into mobile wealth. Hence,as Crow ther observes, “the hank docs “fli create money 0111fir thin ail’, it transmutes other fonns of wealth .