10 main Limitations on Credit Creation

Bank cannot expand deposits to an unlimited extent by granting loans and advances even though this process of granting loans and advances is profitable to them. Their power to create credit is subject to the following limitations:

(i) Total amount of cash in the country

(ii) Cash reserve ratio

(iii) Banking habit of people

(iv) Policy of other banks

(v) The availability of good securities

(vi) Policies of Central Bank

(vii) Initiative of businessmen

(viii) Effects of trade cycles

(ix) Liquidity preference by the people

(x) Leakages

Let us discuss these limitations herein below:

(i) The Total Amount of Cash in the Country:

The banks have power to create deposits depending upon the total supply of cash. The Central Bank of a country has the monopoly power to issue currency notes.

The quantity of money in circulation increases with the issue of more currency and vice versa. Hence, the increased money supply or circulation enables the banks to create more credit. If the supply decreases the banks capacity to create credit will be decreased.

(ii) Cash Reserve Ratio:

The actual cash reserve held by a bank and the cash ratios considered safe in the banking circles, set the limit for creation of credit. Every bank must keep sufficient cash balances to meet the demands of the customers across the counter, and settle the inter-bank ineptness arising out of the clearing house.

The need for keeping adequate cash reserves to meet the claims that arise from currency withdrawal sets a limit to the capacity of a bank to create money. Banks have to maintain the required cash ratios either according to the custom prevailing in the market or as required by law.

In India it is decided by the RBI under Reserve Bank of India Act. This is the minimum cash required to be maintained by a bank with RBI. As per Sec. 42 of RBI Act, this ratio can vary from a
minimum of 3 per cent to a maximum of 15 per cent of net demand and time liabilities (deposits) of a bank. Higher the ratio less is the opportunity for credit creation and vice versa. CRR is an instrument of monetary control.

(iii) Banking Habit of the People:

The banking habit of the people also sets the limit for the capacity of banks to create credit. The volume of employed population, monetary hab­its, etc., determines the amount of cash that the public wishes to hold. The amount of loan given to a customer should again come back to the bank in the form of primary deposits.

Then only there can be credit creation. This is possible only when the banking habits among the people are well developed and they keep their money in the banks as deposits and use cheques for the settlement of their claims.

(iv) Policy of Other Banks:

The credit creation is possible if all the banks in the industry follow the uniform policy regarding maintenance of cash reserves.

If certain banks follow the conservative loan policy and keeping high rate of cash reserves while others are freely lending with minimum cash reserves, the creation of credit will not be up to the extent as determined above i.e., the volume of the credit created will not be up to the extent of the credit multiplier.

(v) Availability of Good Securities:

The availability of good securities, i.e., the securities acceptable to bank places a limit on credit creation by the banks. While lending, the banks insist upon the securities from the customers. All type of assets are not acceptable to banks as securities.

They lend only on liquid assets such as gold, bills, raw materials, etc. As Sayers said, the banks do not create credit by lending to everybody “but to those individu­als who can offer to the banks the kind of assets which the bank thinks attractive”.

(vi) Policies of Central Bank:

The capacity of credit creation by banks is largely depends upon the policies followed by the Central Bank from time to time. The total supply of cash depends upon the policy of the Central Bank.

As the Central Bank can control the supply of cash through various weapons of credit control such as bank rate, open market operations and variation of cash reserves the upper limit of the volume of bank deposits is absolutely determined. Thus, the Central Bank can control the creation of credit by increasing or re­ducing the total supply of cash in the economy.

(vii) Initiative of Businessmen:

The banks can create credit if only the customers are willing to borrow from them. The capacity of the banks to create credit depends upon the psychology and initiative of businessmen and general market conditions for good business activities.

(viii) Effects of Trade Cycles:

The effects of trade cycles also place the limitation on the credit creation, i.e., the conditions of inflation and deflation set a limit on the creation. During the period of economic prosperity there will be greater demand for bank loans and therefore, they can create greater volume of credit. But in times of recession, there is no prosperity and the business people will hesitate to borrow. Therefore, the volume of bank credit will be low.

(ix) Liquidity Preference by the People:

If the general public is highly driven to keep more amounts of cash with them, the banks cannot get adequate deposits to create credit and thus, the liquidity preference by people place a limitation on the creation of credit.

(x) Leakages:

The credit creation by the banks is subject to certain conditions. If there is any leakage in this process the credit creation by the banks will be limited. In credit creation- it is expected that the banks lend the entire amount of excess deposits over the minimum statutory reserve.

And if there is any down fall in such lending, it will affect the creation of credit to that extent. Likewise it is expected that people who borrow money will deposit the same in their respective banks.