Creation of credit is a major function of a commercial bank. When a bank creates credit or advances loans, there tends to be a multiple expansion of credit in the banking system.
Prof. Sayers remarks, “Banks are not merely purveyors of money but, also, in an important sense, manufacturers of money.”
A bank’s demand deposits are regarded as money, as every depositor can meet his obligation through cheques drawn on his deposit account.
A bank’s demand deposits form an overwhelming proportion of the total supply of money in a modern economy, and changes in the amount of bank deposits obviously mean changes in the stock of money in the community.
A bank’s demand deposits arise mainly from: (i) cash deposits by customers, and (ii) bank loans and investments. The former are termed primary deposits and the latter, derivative deposits.
Primary deposits arise from the actual deposits of cash in a bank made by its customers. In receiving such deposits, the bank plays a passive role.
The customer’s decision to deposit cash is the real and active force in determining the size of primary deposits. The creation of primary deposits is, however, nothing but transforming the currency money into deposit money, leaving the community’s money stock unchanged.
The bank may take the initiative in creating claims against itself and in favour of its clients to whom the loans have been sanctioned or of a seller of assets or securities acquired by the bank.
Usually, when a bank grants a loan to a customer or purchases securities from a seller, instead of paying cash immediately, it opens a deposit account in the name of the customer or the seller, credits him with the amount of loan granted or the value of the security purchased, subject to withdrawal by cheque, as required.
It is on account of such a custom that we have the banking maxim, “every loan creates a deposit.” These actively created deposits are called derivative deposits, which arise from granting of loans or through the purchase of securities or assets by the bank.
The size of the derivative demand deposit is determined by the bank’s lending and investing activities to the extent that the bank creates such deposits on its books in favour of those to whom it has granted loans or from whom it has bought securities.
A derivative deposit, since it is actively created by the bank, increases the community’s ownership of demand deposits, without causing any reduction in the people’s holding of currency, hence, it results in an increase in the total stock of money with the community.
Primary deposits serve as a basis for creating derivative deposits, that is, credit creation, and for increasing money supply.
Commercial banks are profit seeking institutions and when, from experience, they find that a large volume of cash received through primary deposits lies idle because all such demand deposits are not withdrawn at the same time by their customers, they use these resources for advancing loans or for making investments in securities, shares, etc., thereby earning a high rate of interest.
Each bank, however, follows a customary cash-reserve ratio for the sake of liquidity and safety. Some cash reserves are necessary in order to honour the cheques drawn on the demand deposits.
Thus, the excess cash reserve, that is, the amount of cash realised in excess of requirements, can be used to create derivative deposits.
The creation of deposit money by banks is basically dependent on their excess cash reserves, or the reserve ratio, to view it from another angle. But the commercial banking system, as a whole, can expand credit many times over the initial excess reserves.
A simplified hypothetical example is given here to illustrate the process by which multiple credit expansion by a “commercial” banking system takes place.
Let us assume that 20 per cent is the customary cash- reserve ratio observed by the commercial banks. Now, if somebody deposits Rs. 1,000 in the Bank of India, the balance sheet of the bank.
If the ratio is 20 per cent, the bank has to keep Rs. 200 as cash reserve requirement, and the rest of the fund (excess reserve), can be used for granting credit. Since loans create deposits, and equivalent derivative deposit is created.
As noted in the balance sheet of the Bank of Baroda, the increased deposit liabilities of Rs. 800, accompanied by an equivalent in cash reserves of Rs. 800 have resulted in excess reserves of Rs. 640, on account of the 20 per cent cash reserves ratio.
Thus, Bank of Baroda is now in a position to expand its loans and deposits by the amount of its excess reserves. If Bank of Baroda expanded its loans and deposits by the amount of its excess reserves, its balance sheet would then change to
The balance sheet shows that Canara Bank now has an excess reserve of Rs. 512 which can be loaned out and which in turn creates a derivative deposit of Rs. 512.
It follows from this that, as the process continues, every time the liabilities with the banks go on increasing at a diminishing rate.
This process will continue to operate until all the original excess reserves of Rs. 800 with the first bank have been parceled out among the various banks and have become the required reserves.
As a result, it may be found that the aggregate of derivative deposits in the entire banking system, over a period of time approximates five times the initial derivative deposit (credit).
In the above example, the credit expansion (DD) is five times the initial excess reserves (ER) of Rs. 800. Thus, the propagated magnitude of credit is Rs. 4,000. Here, cash reserve requirement (RR) is 20 per cent or 1/20
In fact, the potential credit expansion or creation of derivative demand deposits through loans and investments of the bank is determined by the credit multiplier coefficient, which is the reciprocal of the cash reserve ratio, Thus:
Further, it may be observed that, ADD is directly proportional to ER and inversely proportional to r.
The banking system as a whole can grant new credit upon an amount several times the size of its excess reserve, that is, as per the money-creation multiplier or money- creation coefficient, which is equal to the reciprocal of the cash reserve ratio.
Thus, the potential increase in loans and deposits, in our example, is:
ΔDD = Rs. 800 x 5= Rs. 4,000.
The bank deposit multiplier, discussed about is based on the following assumptions:
1. The banks always adjust their asset balances with a view to maintaining a fixed relationship between their deposit liabilities and cash reserves, under the liquidity motive.
2. The cash reserve ratio remains constant through all the stages.
3. There is no leakage in the flow of credit and derivative demand deposits, in turn, become primary deposits with the banks. This means that there is popular banking habit in the country and a well developed banking system.
4. There is no credit control policy of the central bank.
5. The business conditions are normal.
Relation of Time Deposits to Bank Credit Expansion:
No time deposits are quasi-money or near-money, but not a means of payment because they are or chequeable.
The money supply is not increased by people’s habit of accumulating their savings in savings deposits, in fixed accounts or savings accounts of commercial banks. Time deposits, however, do add to public holdings of highly liquid assets.
Another impact of the increase in time deposits is that it absorbs a modest part of the available cash reserves of a bank, since it must hold legal reserves against time deposits also, and, to that extent, it reduces the reserve base for creating derivative demand deposits.
Finally, in the context of money creation by the commercial banks, it should be noted that banks, however, generally require some sort of collateral security from the borrowers of loans.
What the bank is really doing when it lends is to turn such securities, temporarily, into money, in the form of bank’s deposits. Instead of saying that by lending bank-created money, a banker might prefer to say that a bank turns liquid securities into money.
There is, in fact, an exchange of claims when bank deposits are created. The public offers a claim of some sort, some collateral securities and the bank creates a debt by creating bank deposits while granting loans.
As Sayers points out, the economic significance of the exchange of claims lies in the fact that claims against the bank, a debt which did not previously exist, can be used as a means of settlement of obligations.
It is money, whereas the debt, against which it was exchanged, is not money. The operation adds to the total supply of money.
A bank demand deposit serves as money and, therefore, besides representing so much purchasing power, it acquires importance because of its dynamic function of inflencing the level of economic activity.