A bank differs from other financial institutions because it can create credit. Banks have the ability to expand their demand deposits as a multiple of their cash reserves. This is because of the fact that demand deposits of the banks serve as the principal medium of exchange, and, in this way, the banks manage the payments system of the country.
In short, multiple expansion of deposits is called credit creation and the ability of the banks to expand the deposits makes them unique and distinguish them from other non-bank financial institutions. Demand deposits are an important constituent of money supply and the expansion of demand deposits means expansion of money supply.
The whole structure of banking is based on credit. Credit means getting the purchasing power (i.e., money) now by a promise to pay at some time in future.
In the words of Kent, “Credit may be defined as the right to receive payment or the obligation to make payment on demand or at some future tune on account of an immediate transfer of goods.” In a sense, the words credit, debt and loan are synonymous; credit or loan is the liability of the debtor and the asset of the bank. The word credit is derived from a Latin word ‘credo’, which means ‘I believe’.
The creditor believes that the debtor will return the loan and so decides to give the loan. Advancing credit or loan essentially depends upon the (a) confidence, (b) character, (c) capacity, (d) capital, and (e) collateral of the debtor.
Bank credit means bank loans and advances. A bank keeps a certain proportion of its deposits as minimum reserve for meeting the demand of the depositors and lends out the remaining excess reserve to earn income. The bank loan is not paid directly to the borrower but is only credited hi his account. Every bank loan creates an equivalent deposit in the bank. Thus, credit creation means multiple expansions of bank deposits. The word ‘creation’ refers to the ability of the bank to expand deposits as a multiple of its reserves.
In nutshell, credit creation refers to the unique power of the banks lo multiply loans and advances, and hence deposits. With a little cash in hand, the banks can create additional purchasing power lo a considerable degree. It is because of the multiple credits creating power that the commercial banks have been aptly called the ‘factories of credit’ or ‘manufactures of money’.
In the words of Newlyn. “Credit creation refers to the power of commercial banks to expand secondary deposits either through the process of making loans or through investment in securities.”
According to Halm, “The creation of derivative deposits is identical with what is commonly called the creation of credit.”