Credit Creation; Role of RBI and Commercial Banks

1) What is credit creation?

Credit creation refers to the process by which commercial banks, through lending activity, create deposit money (bank deposits) that becomes part of the money supply.

Key idea:

• When banks grant loans, they typically credit the borrower’s deposit account.
• This increases deposits in the banking system, expanding money supply (especially broad money).

2) How banks create credit: the deposit expansion mechanism

Assume:

• People deposit cash in banks.
• Banks keep a fraction as reserves and lend the rest.
• Loans are spent and become deposits in other banks.
• The process repeats.

2.1 Simple illustration (no cash leakage, no excess reserves)

Suppose:

• Initial deposit = 100
• Required reserve ratio (rr) = 10%

Round 1:

• Bank keeps 10 as reserves, lends 90

Round 2:

• 90 becomes new deposit elsewhere
• Reserves = 9, loan = 81

This continues. Total deposits created approach:

In real life, leakages occur:

• cash withdrawals (currency-deposit ratio),
• excess reserves held by banks, so expansion is smaller.

3) Limitations of credit creation (important)

Credit creation is not unlimited because of:

1. Reserve requirements (CRR) and liquidity norms
2. Cash leakages (public withdraws currency)
3. Excess reserves (banks hold more reserves due to risk/uncertainty)
4. Capital adequacy norms (Basel norms)
5. Credit demand (if borrowers don’t want loans, lending won’t expand)
6. Risk and NPA concerns (banks may restrict lending)

4) Role of commercial banks (core functions)

Commercial banks:

• accept deposits (demand/time),
• provide loans and advances,
• facilitate payments (cheques, transfers),
• create deposit money via lending,
• support financial intermediation and economic growth.