Credit Creation: Meaning and Limitations on Credit Creation

Creation of credit is one of the most outstanding functions of a modern bank.

A bank has sometimes been called a factory for the manufacture of credit.

Let us see what we mean by credit creation, how it is created by the bank and, finally, whether the power of the banks to create credit is unlimited or it is subject to certain limitations.

What is Credit Creation?

It is an open secret that the banks do not keep cent per cent reserve against deposits in order to meet the demands of depositors. The bank is not a cloak room where you can keep your currency notes or coins and claim those very notes or coins back when you desire. It is generally understood that money received by the bank is meant to be advanced to others. A depositor has to be content simply with the bank’s promise or undertaking to pay him back whenever he makes a demand.

This bank is able to do with a very small reserve, because all the depositors do not come to withdraw money simultan­eously; some withdraw, while others deposit at the same time. The bank is thus enabled to erect a vast superstructure of credit on the basis of a small cash reserve. The bank is able to lend money and charge interest without parting with cash. The bank loan creates a deposit or, as we have seen above, it creates a credit for the borrower.

Similarly, the bank buys securities and pays the seller with its own cheque which again is no cash; it is just a promise to pay cash. The cheque is deposited in some bank and a deposit is created or credit is created for the seller of the securities. This is credit creation.

Thus, term ‘credit creation’ implies a situation, to use Benham’s words, when “a bank may receive interest simply by permitting customers to overdraw their accounts or by purchasing securities and paying for them with its own cheques, thus increasing the total bank deposits.”

Let us see in detail how credit is created

Limitations on Credit Creation:

From the account of credit creation given above, it would seem that the banks ‘reap where they have not sown’. They advance loans or buy securities without actually paying cash. But they earn interest on the loans they give, or earn dividends on the 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 profit, like this, as they can.

But they cannot go on expanding credit indefinitely. In their own interest, they have to apply the brake and they do actually apply it, for it is well known that the profits made by the banks are not very high. The overriding limitation arises from the obligation-of the banks to meet the demands of their depositors.

Benham has mentioned three limitations on the powers of the banks to create credit: ;

(i) The total amount of cash in the country;

(ii) The amount of cash which the public wishes to hold; and

(iii) The minimum percentage of cash to deposits which the banks consider safe.

As for (i), it may be said that credit can be created on the basis of cash. The larger the cash (i.e.. legal tender money), the larger the amount 0f credit that can- be created. But the amount of cash that a bank may have is such to the control of the Central Bank.

Here it may suffice to say that the Central bank has the monopoly of issuing the cash. It may increase it or decrease it, and  expand or contract accordingly. The power of the central bank to control currency is thus the controlling influence on the extent of credit, that Create.

The second limitation arises from the habit of the people regarding 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 granted by the bank to a borrower, he will draw the cheque and gel cash. When the bank’s cash reserve is thus reduced, its power to create 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., U.K. and other European countries. There the banks keep only 4-5 per cent cash reserve.

The third limitation is the most important. It arises from the traditional reserve ratio of cash to liabilities which the banks must maintain to ensure their own safety and to maintain the degree of liquidity that is considered desirable. It is clear that when a bank creates a credit or grants 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 credit comes to an end. To grant any further credit will be risky unless the bank’s experience is reassuring enough to permit the adoption of a lower percentage. Then that would become 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 or some security). An asset is a form of wealth. Thus the bank only turns immobile wealth into mobile wealth. Hence, as Crowther observes, “the bank does not create money out of thin air, it transmutes other forms of wealth into money.”

To sum up: The essential conditions for the creation of credit are that the banks obtain fresh cash reserves, they should be willing to lend and the businessmen should be willing to borrow, and the borrowers should not withdraw the amount of the loan, but be content to leave it in the form of deposits with the bank. The initiative is in the hands of the borrowers. The deposit is, in fact, created not by the amount borrowed, but by the amount not withdrawn.

Liquidity vs. Profitability:

Let us now consider the essentials of sound banking. We have seen that a bank can lend large amounts of money on the strength of a small cash holding. That is why this is called ‘creation of credit.’ If, tempted by easy profits, it carries this practice too far and does not keep adequate reserves, it may get into trouble. Even a small ‘rush’ on it may land it in the bankruptcy court. Further, if the bank locks up its funds in long-term investments (like factories, lands and houses which cannot be sold at a pinch), it may have to close its doors one day.

We may then conclude that for achieving soundness:

(a) A bank should not advance funds for speculation;

(b) It should not invest heavily in industrial undertakings which yield returns only after long periods;

(c) It should not lend very large sums of money to an individual borrower or a particular group of borrowers; If they fail, the bank may have to face ruin;

(d) It should maintain a high ratio of cash to deposits, loans and advances. Its other reserves should be as liquid as possible.

Thus, on the one side are profits and on the other reserves. High reserves mean less profit. The bank has to follow a path midway between the two extremes. It should strike a happy compromise between liquidity on the one side and profitability on the other.

It must keep sufficient liquid assets so that it may be able to meet the demands of the depositors. If the bank itself speculates, it may have to face disaster one day. The early history of joint-stock banking in India is full of examples where a bank had to close doors on account of its speculative activities.

There is no fixed principle about the proportion of reserves to liabilities. In the last resort, the amount of reserve depends upon the normal demands of a bank’s customers. To meet sudden calls— and no one can predict them—the bank’s investments should be as liquid as possible so that they can be easily converted into cash.

Nowadays every bank has to keep a percentage of its deposits with the Central Bank of the country. These balances, called bankers’ deposits, are as good as money in the bank’s own till. The Central Bank uses them as a handle to control its member banks and the total issue of credit in the country. They are also used to help member banks in an emergency, if otherwise they are sound.

It is seen that in countries, where the people are educated and bank- minded, the ratio of reserves to advances is lower than in backward countries. In the U.K., this ratio sometimes falls as low as 3 per cent while in India it is usually much higher. The ratio is lower in the case of old banks with a reputation than in the case of smaller new banks. Deposit insurance schemes are intended to inspire faith among the people in the banking system and thus give it strength and stability.