What are the limitations of credit creation?

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Theoretically, the banking system can create unlimited amount of credit through expansion of deposits. However, in reality, the powers of banks to create multiple credit or deposits arc subject to a number of limitations as explained below:

1. Amount of Cash:

The extent of credit creation primarily depends upon the amount of cash possessed by the banks. Larger the amount of cash with the banking system, greater will be the credit creation, and vice versa. In the words of Crowther, “The bankers’ cash is the level with which the whole gigantic system is manipulated.” Thus, the power to create credit is limited by the bank’s cash.

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2. Cash-Reserve Ratio:

The size of credit multiplier is inversely related to the cash-reserve ratio. The higher the cash-reserve ratio, the smaller will be the volume of credit creation and vice versa.

3. Leakages:

The actual credit creation by the banking system may be considerably smaller than the potential credit creation due to certain leakages. There are at least two such leakages in the credit creation process:

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(i) Excess Reserves;

The banks may not be willing to utilise their surplus funds for granting loans and may decide to maintain excess reserves. Such a situation arises (a) when there are fear of significant rise in future interest rates or (b) when the economy is heading towards a recession. The greater the excess reserves, the smaller the credit multiplier.

(ii) Currency Drains:

The credit creation multiplier mechanism assumes that the amounts of loans granted by the banks return to them by way of new deposits. However, the public may not keep the whole amount of loans in the banks and may withdraw some cash to hold it with themselves. This cash withdrawal or currency drain reduces the power of the banks to create credit.

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4. Availability of Borrowers:

Banks create credit by means of loans and advances. Therefore the extent of credit creation depends on the availability of borrowers. If there are no borrowers, there will be no credit creation.

5. Availability of Securities:

Bank loans are granted against securities. In the words of Crowther, “the bank does not create money out of thin air; it transmutes other forms of wealth into money.” Thus, the power of the bank to turn other assets into money (i.e. to create credit) is restricted by the availability of good securities.

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6. Credit Policy of Other Banks:

All banks may not adopt the same credit policy. If some banks decide not to utilise their full capacity for credit creation and keep large cash reserves, the credit creation in the country will be limited to that extent.

7. Banking Habits:

Development of banking system and the banking habits of the people also influence the extent of credit creation. If people prefer to make transactions through cash and not by cheques, the banks will be left with a smaller cash and there will be lesser credit creation. Banking habits, in turn, depend upon the development of banking system. In the developed economics due to the large expansion of banking facilities, the banking habits are more conductive to credit creation than in developing economics.

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8. Business Conditions:

Credit creation is further limited by the nature of business conditions. During depression, when due to low profit expectations businessmen do not come forward to borrow from banks, credit creation will be very small. On the other hand, during the period of business prosperity, the profit expectations are high, the businessmen approach the banks for loans and there will be greater credit creation. Hence credit creation will be smaller during depression and larger during business prosperity.

9. Monetary Policy:

The extent of credit creation largely depends upon the monetary policy of the central bank of the country. The central bank has the power to influence the money supply in the country. It can use various methods of credit control to influence the banks to expand and contract credit.

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