Limitations in the Creation of Credit on the Part of Commercial Banks

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It must be noted that commercial banks do not have unlimited powers of deposit or credit creation, because their activities in this direction are subject to a number of restrictions.

The limitations in the creation of credit on the part of commercial banks are many.

1. Amount of Cash:

The first important factor on which the extent of credit creation depends is the amount of cash which commercial banks possess. The larger the amount of cash with the banking system, the greater will be the excess funds and hence larger will be the credit creation power of the bank.

As Crowther puts it, "The bank's cash is the lever with which the whole gigantic system is manipulated." But the bank's cash is not any form of money that the bank itself can create or expand at will.

The bank's power of creating money or credit is thus limited by the cash it can get its hand on, primarily through primary deposits.

2. Cash Reserve Ratio:

As we have seen, credit multiplier coefficient is the reciprocal of the cash reserve ratio. The higher the percentage of cash reserve ratio to be kept, the smaller the relative excess funds and smaller the volume of credit creation, and vice versa.

3. External Drain:

The most important factor, according to Whittlesey, which restricts credit expansion, is "external drain". As we have seen, on the basis of the excess reserve, commercial banks can expand their credit by creating demand deposits.

Some of the borrowers from these banks are likely to withdraw part of their deposits in currency. Every rupee in cash that is withdrawn from the banking system lowers the reserves of the banks, and thus checks further deposit expansion.

In short, an external drain refers to the cash withdrawal from the banking system by the public; it lowers the reserves of the banks and partly destroys the power of banks to create credit.

4. Willingness of Customers to Borrow:

Bankers cannot create credit at will. The amount of credit is conditioned by the needs and will of the borrowers. The amount of borrowing by the customers sets a limit to the expansion of credit; if no customer comes forward to borrow, there is no expansion of credit.

This may happen in times of depression when even a sufficient reduction in the interest rate may prove to be ineffective for credit expansion.

Credit creation depends on the demand for loans, which in turn, depends upon the nature of business conditions. Credit creation, therefore, will be larger during a period of business prosperity, and smaller during a depression.

5. Supply of Collateral Security:

The availability of good securities places one more limitation on the power of banks to create money. Every loan made by a bank is secured by some valuable form of wealth bills, shares, stocks, etc.

"Thus, the bank does not create money out of thin air; it transmutes other forms of wealth into money." Hence, what a bank really does when it creates credit is to extend liquidity to holders of liquid securities.

Clearly then, the power of the bank to turn liquid assets into money depends on the volume of such assets or securities with the borrowers. If approved securities are not available, the bank cannot create credit without inviting trouble.

6. Banking Habits and Banking System:

Development of the banking system and banking habits among the people is an important factor. If people prefer to transact by cash and not by cheques, then multiple credit creation by the banks will not be possible. The banking habit will become popular only if there is a sound, developed banking system.

7. Monetary Policy of the Central Bank:

In the modern economy, the extent of credit creation will largely depend on the monetary policy of the central "bank.

The central bank has the power to influence the volume of money in the country and from time to time, uses various methods of credit control which affect the process of bank credit expansion.


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