Though banks would like to have an unlimited capacity to create credit so as to add to their profit income, in practice they face several hurdles in doing so. These limitations manifest themselves in converting additional credit creation into a non-profitable activity. Thus, a bank would keep creating additional credit so long as:-
(i) Loans extended by it have only a negligible chance of becoming bad debts.
(ii) There is a reasonable difference between the interest, which the bank has to pay on its borrowings and deposits. The interest, which it charges from its own borrower. In other words, the limitations of credit creation by banks operate through shifts in their balance between liquidity and profitability.
We may look at the limitations on credit creation by banks by considering
- Their capacity to create credit.
- Their willingness to create credit.
- Armand for credit in the market.
Capacity to create credit is a matter of (i) the availability of cash to bank, and (ii) the factors that determine their cash deposit ratio. These factors have been discussed above. We have also seen that a bank is willing to create credit so long as it estimates that it will be profitable to do so. As regards the demand for credit, a bank can extend loans only to those who are ready to borrow. It is noteworthy that a bank would not give loan to a borrower who is not considered creditworthy by it. Also, in any case, the amount of the loan would not exceed the paying capacity of the borrower.
Similarly, given the interest rate, a genuine borrower would not apply for a loan, which exceeds his requirement. Under normal circumstances, the demand for credit gets fully satisfied when expected marginal profitability of new investment declines and becomes equal to rate of interest.
In many situations, due to a policy pursued by the central bank, it is difficult to get fresh loans from the banks and we get the impression that demand for credit is unlimited. But factually it is not so. A persistent excess demand for credit exists only under inflationary conditions. But these conditions cannot last forever because continuous inflationary pressure can disrupt the financial system itself. In other words, the concept of a limitless demand for bank credit is only an illusion and not a reality.