8 Main Determinants of Total Bank Credit | Supply of Money

The following points highlight the eight main determinants of Total Bank Credit. The determinants are: 1. Excess Reserves 2. Reserve Ratio 3. Banking Habits of the People 4. Availability of Collateral Securities 5. Existing Business Conditions 6. Expansion of the Banking System 7. Legal Reserves 8. Cash Leakage.

Determinant # 1. Excess Reserves:

The credit-creating capacity of banks depends on the total amount of excess reserve being held by the banking system as a whole per period. The amount of deposit created varies directly with the amount of excess reserve.

Determinant # 2. Reserve Ratio:

The maximum amount of credit which can be created by the banks also depends on the reserve ratio maintained by the banking system as a whole. If the central bank raises the minimum-reserve ratio, then the amount of deposit created by the banking system as a whole will fall. The converse is also true.

Determinant # 3. Banking Habits of the People:

The credit creating capacity of the commercial banks also depends on the banking habits of the people. In industrially advanced countries the banking habits of the people are well- developed and most of the transactions are settled through cheques. Obviously, the credit creating capacity of the commercial banks are higher in such countries.

In developing countries like India just the opposite is true. Banking facilities are not available in most rural areas where 70% of the people live. Moreover, banking habits are not well-developed in such countries. In fact, the prevalence of the barter system and lack of monetisation in most developing countries of Asia, Latin America and Africa obstruct multiple credit expansion by the banking system

Determinant # 4. Availability of Collateral Securities:

Banks normally demand securities for giving loans. If the borrowers do not have sufficient acceptable securities to offer then the total amount of deposits created by the banking system will be low. Even if banks are eager to lend, they cannot expand their volume of loan.

Determinant # 5. Existing Business Conditions:

The amount of credit which can be created by the banking system as a whole depends on the state of the economy or, to be more specific, on existing business conditions. If the economy is expanding, there will be more demand for goods and services. As a result profit prospects will be bright.

So business people will be eager to produce more because they can sell more. Hence they will take more loans and the demand for bank loan will increase. This will make it profitable for the banks to expand the volume of credit. In contrast, if the economy is in depression banks cannot create much credit. It is because there will not be much demand for bank loan in such times.

Determinant # 6. Expansion of the Banking System:

The total amount of credit which can be created by the banks depends on the expansion of the country’s banking system. If the banking system is well-developed and if there are many banks in the country, the credit-creating capacity of banks will be high.

It is because the total amount of credit that can be created by the banking system as a whole is a multiple of the total excess reserves of the banking system. But a single (monopoly) bank in the system cannot create credit (deposit) exceeding its own excess reserve.

Determinant # 7. Legal Reserves:

If the legal reserve is 10%-but commercial banks keep 20% reserve, the deposit (credit) multiplier will be 5 and not 10. Thus if there is an initial increase in cash deposit of a bank of, say, Rs. 1,000, the total increase in bank deposit at the end will be only Rs. 5,000 and not Rs. 10,000. This is what happens in countries like India having underdeveloped money markets.

Determinant # 8. Cash Leakage:

If depositors withdraw a certain amount of money for spending (transactions) purposes, banks will be left with less cash. Thus, if people’s transaction demand for money increases, the amount of cash with the non-bank public will also increase. This will reduce the credit- creating capacity of commercial banks.

In short, the capacity of commercial banks- to create credit depends not only on their own cash requirements but also on the cash requirement of the public or of the non-banking system. Their own cash requirement depends mainly on the monetary (credit) policy of the central bank.

The central bank often limits money supply growth in order to slow down the economy and control inflation. But the cash requirement of the public depends on transactions demand for money, i.e., the amount of money people demand for spending purposes.