CREATION OF CREDIT BY COMMERCIAL BANKS

 CREATION OF CREDIT BY COMMERCIAL BANKS

         
                                                                          Commercial banks deal in money, i.e., they borrow money from those who have surplus, and lend it those who are in need. As they deal in money , they are called 'dealers in money' or 'purveyors (suppliers) of money' . In addition to borrowing and bending of money, commercial banks 'manufacture' or 'create money'. So, they are called 'manufacturers of money'. According to R.S.Sayers, "Banks are not merely purveyors of money, but also in an important sense, manufactures of money"
            Deposits received by banks can be classified into two. They are (i) Primary Deposit (ii)Derivative or Active Deposit.

1. Primary Deposit 
                                                                When a bank receive cash from a depositor, opens an account in the name of depositor and credits the amount received to the depositors account, bank deposit arises. Such bank deposits are called primary deposits, 'passive deposits' or 'cash deposits'. This deposit form the basis for the loan transactions of a bank.

2. Derivative Deposits
                                                                       Using the cash received from the depositors, the banks grant advances to businessmen or buys assets such as bills, bonds, etc. from the market. Whenever a bank grants a loan or buys an asset it does not usually pay cash for it. Instead of paying the cash, the bank actually places the amount of loan in the account of the borrower. thus the borrower acquires a claim against a bank just as he has deposited a sum of money. These deposits are derived from the primary deposits and hence they are known as ' derivative deposit' or 'secondary deposits' or 'active deposit'. If the banker has more primary deposit, he can lend more and create more deposit. The unit value for creating the derivative deposit comes from the banking system.
                                                                     By experience, banks know that all depositors do not withdraw their money simultaneously. Some withdrew while some others deposit in the same day. So by keeping a small cash reserve for day to day transactions, the bank is able to grant loans on the basis of excess reserves. The amount lent may come back again to the same bank or some other bank as deposit. The bank whose deposits have increased will lend more to public. This process will continue till the total deposits have increased by number of times the original deposit of cash.

Various ways of creating money
       Banks can create money in several ways. They are
1.  Loans and advances; Banks provide credit facilities to businessmen by way of loans and advances, overdraft and cash credit. When a loan is granted or overdraft is sanctioned, the amount of loan or overdraft is entered in the account of the customer and he is allowed to draw cheques upto the amount agreed upon. Thus the bank creates a deposit in the name of the borrower. Banks can create credit by making more loans and advances.
2. Discounting of bill; When a bank discounts a bill of exchange, the net proceeds of the bills are generally not paid to the discounter in cash. They are just credited to the deposit account opened in the name of the discounter. Of course, the discounter can make use of the deposit by issuing cheques .
Thus when a bill is discounted, additional supply of money arises in the country. So we can say that banks can create money by discounting bills of exchange.
3.  Investments; A commercial banks also creates a deposit by making investment in securities like government bonds,shares,debentures. When a bank buys some securities, it does not usually pay the seller of securities in cash. Instead, it opens a deposit account in the name of the seller of securities and credits the deposit account with the price of the securities purchased.
4.  Creation of money by purchasing fixed assets; When a bank purchases a fixed asset, say, a building for its own use, usually, it does not pay the seller of the fixed asset in cash. It simply opens a deposit account in the name of the seller and credits the deposit account with the price of the fixed asset purchased. The seller of the fixed asset can use the deposit for any purpose he wants by issuing cheques.

'Loan create deposits' and ;deposits create loans'
                                                                        According to Hartley Withers, 'Loans makes deposits', i.e., loans and advances creates new deposits. This statement is absolutely correct. When a loan or OD or CC is granted to a borrower, amount sanctioned by the banker is usually not given to the borrower in cash. But it is credited to the deposit account opened in the name of the borrower. Therefore, one is right in saying that all form of advances, create deposits or deposits are the children loan.
                                                                     Just as loans create deposits, deposits (i.e., primary deposits) also create loans. A bank can advance money in various forms only it has cash or primary deposits in its hands. Thus, the various forms of advances are made possible by the primary deposits in the hands of a bank. Hence the statement. "deposits(i.e., primary deposits) create loans (i.e., all forms of advances) or loans are children of deposits".

Technique of credit creation
                                                                     Deposits create loans and loans create deposits. A bank can advance money in various forms only if it has cash or primary deposits in its hands. Thus the various forms of advances are made possible by the primary deposits in the hands of a bank.
      The process of credit creation is based on certain assumptions which are as follows.
1. There are a number of banks in the country, because otherwise the amount lent may not come back to the bank and fresh deposits will not arise.
2.There is no leakage. The amount lent is deposited in the same bank or with some other bank.
3. All banks keep the same percentage of cash reserves.