Credit creation is a unique function of commercial banks where they expand the money supply in the economy by creating “Secondary Deposits” through the lending process. Unlike the Central Bank (RBI), which prints physical currency (High-Powered Money), commercial banks create “Bank Money” or “Credit Money.”
The Process of Credit Creation
The process is based on the principle that banks do not need to keep 100% of their deposits as cash; they only need enough to satisfy the daily withdrawal demands of depositors.
Primary vs. Derivative Deposits
- Primary Deposits: These are cash deposits made by the public into their bank accounts. They are the starting point of credit creation.
- Derivative (Secondary) Deposits: When a bank grants a loan, it does not hand over cash. Instead, it opens a deposit account in the borrower’s name and credits the loan amount. This account is a “derivative deposit,” which increases the total money supply.
The Step-by-Step Mechanism
- A depositor places ₹1,000 (Primary Deposit) in Bank A.
- If the Legal Reserve Ratio (LRR) is 10%, Bank A keeps ₹100 as a reserve and lends the remaining ₹900.
- The ₹900 loan is credited to a borrower’s account, becoming a Secondary Deposit.
- This ₹900 (minus the 10% reserve) is then lent out again by the banking system, continuing the cycle until the total credit created is a multiple of the initial deposit.
The Money Multiplier Effect
The total amount of money created by the banking system is determined by the Money Multiplier (k). It is mathematically expressed as the reciprocal of the Reserve Ratio.
k = 1/LRR
Total Credit Creation Formula
Total Credit Creation = Initial Deposit × 1/LRR
- Example: If the LRR is 10% (0.1) and the initial deposit is ₹1,000, the total money supply created will be ₹1,000 × 10 = ₹10,000.
Components of Legal Reserve Ratio (LRR)
In India, the LRR consists of two statutory requirements mandated by the RBI to control the credit-creating power of banks:
- Cash Reserve Ratio (CRR): Under Section 42(1) of the RBI Act, 1934, banks must keep a certain percentage of their Net Demand and Time Liabilities (NDTL) with the RBI in cash. No interest is paid to banks on these reserves.
- Statutory Liquidity Ratio (SLR): Under Section 24 of the Banking Regulation Act, 1949, banks must maintain a percentage of their NDTL in the form of liquid assets like gold, cash, or unencumbered government securities.
Factors Limiting Credit Creation
- Amount of Primary Deposits: Larger initial deposits provide a larger base for lending.
- Legal Reserve Ratio (LRR): There is an inverse relationship between LRR and credit creation. Higher LRR reduces the lending capacity of banks.
- Banking Habits of the Public: If people prefer to hold cash rather than depositing it (high Currency Deposit Ratio), the capacity for credit creation decreases.
- Credit Policy of the RBI: The RBI uses qualitative and quantitative tools (like Repo Rate and Open Market Operations) to squeeze or expand the credit-creating power of banks.
- Availability of Borrowers: Even with high reserves, banks cannot create credit if there is no demand for loans or if borrowers lack creditworthiness.
Summary of Key Ratios and Terms
| Term | Definition | Impact on Credit Creation |
| NDTL | Net Demand and Time Liabilities; the total deposits held by a bank. | Primary base for credit. |
| CRR | Cash reserves kept with the RBI. | Increase in CRR decreases credit. |
| SLR | Liquid assets kept by the bank itself. | Increase in SLR decreases credit. |
| Money Multiplier | The factor by which deposits increase. | Higher Multiplier = More Credit. |
| Credit Multiplier | Same as Money Multiplier; indicates the ratio of change in total deposits to change in reserves. | Central to Monetary Policy. |
Facts for UPSC Prelims
- Institutional Framework: The power to create credit is vested in Commercial Banks, but the power to control that credit lies solely with the Reserve Bank of India (RBI).
- Money Aggregates: Credit creation directly impacts M3 (Broad Money).
- High-Powered Money (H): Also known as M0 or Reserve Money. It includes currency held by the public and bank reserves. Credit creation is the process where H is transformed into a larger M3.
- Excess Reserves: These are reserves held by banks over and above the statutory requirements (CRR and SLR). Only excess reserves can be used for further credit creation.
- Fractional Reserve Banking: The global banking system (including India) is based on this principle, where banks hold only a fraction of their deposit liabilities as liquid reserves.