The following points will highlight the six limitations on credit creation by banks.
They are: 1. Lack of Securities 2. The Business Environment 3. Lack of Cash 4. The Habits of the People 5. Leakages 6. The Central Bank’s Policy.
Limitation # 1. Lack of Securities:
Banks cannot expand deposits by granting loans and advances unless proper securities are available. Crowther observes: “The bank does not create money out of thin air; it transmutes other forms of wealth into money.” The total volume of income- yielding securities available in the country sets the overall limit to the process of credit creation.
Limitation # 2. The Business Environment:
Loans are taken only when sound investment opportunities are available. During recessions and depressions, deposits tend to go down. The business situation in the country is an important factor which determines the volume of credit.
Limitation # 3. Lack of Cash:
ADVERTISEMENTS:
The total amount of cash, available to the banking system limits the volume of credit that can be created. Credit is based on cash. The banks must keep a certain percentage of cash reserve. The total volume of credit cannot ordinarily be larger than the total amount of cash available multiplied by the customary reserve-ratio. The Central Banks control credit by measures, like open market operations and variations of the reserve ratio, which affect the quantity of cash in the hands of the banks and thereby influence their lending policy.
Limitation # 4. The Habits of the People:
The habit regarding the holding of cash can affect credit creation. If liquidity-preference increases, there will be less cash in the hands of the bank and they will be forced to lend less. In countries with an under-developed banking system, the people tend to hoard cash. This reduces the power of banks to create credit.
Limitation # 5. Leakages:
In the chain of deposit creation, as shown in the example given above, there may occur leakages. Some borrowers may keep a part of their money in hand without putting it in a bank. The total volume of deposits will then be lower than the maximum possible. A similar leakage may occur at the bank’s vaults. A particular bank in the chain may choose to keep a higher reserve ratio and lend less.
Limitation # 6. The Central Bank’s Policy:
The policy regarding open market operations etc. may affect the total cash reserves of the banking system and may make the total created credit less or more than what it would otherwise be.