Limitations on Bank’s Power of Credit Creation

Read this article to learn about the limitations on bank’s power of credit creation in an economy.

Theoretically speaking, bank may be described as a factory of credit as it does succeed in creating more purchasing power, but this power of the bank to create credit is not unlimited and is subject to a large number of limitations and control.

It must not be forgotten that the money which the banker creates is his liability. Banks have to meet claims from the public needing actual currency for day-to-day transactions and from their fellow banks in settlement of clearing housebalances.

Moreover, the assumptions that we have made to build the theory of bank credit are not always true of actual life e.g., all people are not habituated to use bank money or to keep bank account or to have full confidence in the bank’s position. Therefore, a bank is not able to create credit at pleasure. One way of understanding the limitation on of banking business of creating money is to study and analyze its balance sheet, as the entire business of a bank is in its balance sheet. A balance sheet is an annual statement of bank’s assets and liabilities. The bank has to observe the principle of maintaining the equality of assets and liabilities.

The balance sheet has the merit of showing at a glance the working of bank. It is also something referred to as bank’s portfolio. Strictly speaking bank’s portfolio shows a classified arrangement of its assets. A wise preparation of bank’s portfolio (assets) is of vital importance as it affects the interests of stock holders, depositors and the general community. An unimaginative lending policy based on the sole objective of earning may lower the liquidity of the bank to such an extent that it may endanger its security. On the other hand, an over-cautious policy will greatly hamper the profitability of commercial banks.

The arrangement of earning assets usually referred as bank’s portfolio is done on the basis of liquidity, solvency and earnings or profitability. Without liquidity the bank cannot meet the depositor’s demand, without solvency, it must ultimately fail and without earning, the banking operations cannot be carried on profitably. These three essential requisites of sound banking are often at conflict. It requires an astute management to reconcile the three and this constitutes the greatest limitation on the power of the banks to create credit money.

The most important limitation on the power of the bank to create credit arises from the need to keep cash to meet its liabilities. Hence, no prudent banker will allow its cash reserve to fall below a certain percentage say 10% or 20%. His whole business depends upon the confidence of the public in his ability to meet his liabilities on demand. As Prof. Crowther says, “the bank’s cash is the level with which the whole gigantic system is manipulated.” The bank’s power of creating money is thus limited by the cash it can get its hands on.

Secondly, the ratio of reserves to deposits (cash-reserve ratio) imposes a limitation on the volume of credit creation. Credit creation is just the reverse of the cash reserve ratio. The higher the ratio, the lower is the power to create credit, e.g., if the cash reserve ratio is 10%, banks will create credit to the extent of 10 times, but if it is raised to 20% credit creation will decline to five times only.

Thirdly, it depends upon the willingness of people to borrow from the banks, if they are not willing to borrow, then the bank cannot just create credit. In other words, bank’s power to create credit is impaired by the nature of business conditions and circumstances prevailing in an economy example, credit creating will be high during prosperity (even though the rate of interest show tendency to rise) and small during depression (even though the rate of interest shows a tendency to fall).

During prosperity, people approach banks for money on account of general wave of optimism and banker’s faith in their ability to pay back, but during depression businessmen do not approach banks for more credit on account of general wave of pessimism and bank’s dwindling faith in their ability to pay. Thus, banker’s business has been aptly compared with a man who is prepared to length his umbrella when the weather is fine but refuses to do so just when it starts raining.

Fourthly, bank’s power to create credit becomes limited by the desire of the general public to hold cash (liquidity preference). If people, for one reason or the other decide to keep hard Cash and do not deposit it in banks, as is the case in underdeveloped countries, where people give more importance to cash money than bank deposits, the power of the banks to create credit becomes limited as they have very little cash reserves or primary deposits on which to base the credit.

Fifthly, the power of credit creation of any individual bank is determined by the policy followed by other member banks with regard to credit-creation. No individual bank can afford to prosper when the rest of the banking community is in distress. “If an individual bank fails to keep up with the general rate of credit expansion, it will receive more cash than it loses and it will, therefore, accumulate excess reserves which it will, tend to loan out. If an individual bank expands loans or investments more rapidly than other banks, it will lose cash, may not be able to fulfill the reserve requirements and will tend to reduce its loans or investments.” Thus, an individual banker can neither afford to go ahead nor lag behind the rest of the banking community in the matter of credit-creation.

Lastly, the extent of credit creation depends upon the policy followed by the Central Bank of a country. Monetary policy followed by Central Bank determines the limit to which credit can be created through its policy of bank rate and open market operations. No member bank can afford to ignore the policy laid down by the Central Bank with regard to credit-creation, as it can influence the banks directly or indirectly to expand or contract credit.

Strong objections have been raised against the theory of bank’s creating credit by writers like Dr. Walter Leaf and Prof. Cannan. They express the opinion that the initiative to create credit lies with the depositor and not with the banker. Banks can create credit merely because depositors don’t withdraw their deposits, rather, these are un withdrawn deposits, that are lent by a bank.

In this respect, there may be no difference between a bank and a cloakroom. Assuming that there are hundred guests at a dinner, each having a similar cloak, which he deposits with a cloakroom attendant outside the gate. Presume, that the dinner will not be over before 11 P.M. However, if some guests go earlier the attendant keeps 20 cloaks in reserve and lends out the rest to be returned by 10.45 P.M. Has he in hiring the cloaks created 80 clocks? This is clearly absurd and so is the myth about banks’ creating credit.

Credit creation process described earlier is, thus, hardly an exact description of the method by which bank money comes into existence and it should never be visualized to be without limitations and qualifications which have been discussed. Despite, there cannot be any doubt that banks create credit, the only practical limit is set by the amount of cash available.