Significance of Credit Creation
Credit creation vitally affects the level of economic activity (and hence national income, output and employment) in the country. It is no wonder that the policy pursued by the monetary authority in the country is directed to the control of credit expansion or contraction. Left to itself, credit expansion or contraction may ‘boom the booms’ and ‘depress the depressions.’ Thus, credit creation has a lot to do with the cyclical fluctuations in the economy. In the case of under-developed economies, credit creation has to be controlled to ensure economic .
bank exists to make profit. Its investment policy is, therefore, mainly governed by the profit motive.But a bank is a very sensitive institution and must always keep in view its own security. ‘Safety lir~t’ is the rule and subject tu this, the bank must try to make maximum profit. Thus, profitability and safety (i.e .. liquidity) are the two considerations governing a bank’s investment, although it is not easy to reconcile
them. If the bank management IS more keen on making’ profits. it may invest its funds in lines which arc highly remunerative hut which may not be converted into cash quickly when the need arises. On the other hand, if the bank is swayed only by safety considerations, it may not earn much profit because safe investments arc
generally not very rcmuncratve, The secret of sound banking consists in the maintenance of adequate reserves. while at the same time.
making profits. A bank. we have seen. deals with other people’s money ti.e.. deposits) and the money can he withdrawn with or without notice. They IIlUSt. therefore, maintain adequate reserves to meet this demand and niake profit by lending the rest. A wise banker must maintain a proper-balance between liquidity and profitability. Too much caution will mean too little profit, while reckless lending may endanger the safety of the bank itself. The liquidity and profita bility are opposing considerations. There has to be a compromise, but it is anuneasy compromise. Because whatever the form and quantity in which the banks keep their reserve. they are found to be unnecessary in normal times and insufficient hen the depositors’ confidence is shaken. In order to ensure liquidity for their own safety, abank must keep adequate reserve. The amount of reserve kept by a bank is governed, among others, by three factors 5 : (a) day-to-day fluctuation in the amount of bank’s deposits; <IJ, the variability of the customer’s borrowing needs; and (c) the nature of secondary reserves, and the character of reserve organisation in the banking system. Importance IIf Li(fllidil)·. Th e proportion inwhich the various form of assets are kept vary from Country to ,country, from bank 10 bank, and vary also with the state of trade .The larger the ‘liquidity’ of the assets, the more confidence will a bank inspire, but the lower wfll be its .profits The whole banking business rests on the confidence of the people in the ability of the bank to pay their money back on demand. If such confidence isshaken for any reason. there is a ‘run’ on the bank.
No bank can face a run because all the assets of thebank are not in liquid form,
Banking business is said to bc a ‘fair weather’ business. So long as the skies are sunny. i.e., so long as thc depositors are happy with the bank and nobody wants to withdraw his money, the bank says, “Anybody can have his money hack.” Out as soon as the skies are overcast and the depositors get nervous and all depositors wish to take out their money. then nonc can have it. If there is only a single patch of colour on the sky. if only one bank is involved in a run, it may perhaps be able to meet its liabilities by converting its assets into cash. nut if the whole atmosphere
is gloomy. and there is a general pa nic. depositors of all banks will have to go disappointed. that people’s confidence in its sourdough is not shaken. Bankers must take into account a certain degree of proclivity on the pall of the depositors. When
they know they can have their money back. they do not have it. and as soon as they suspect they cannot have it, they insist on having ·it. The best way to inspire confidence is freely to give credits in times of panic. Central banks also come to the help or other bunks on such occasions.