Credit creation

& Credit
controls
Vishnu Thankachan
S3 MBA
No: 029

Need for Credit Creation

Commercial banks are called the factories of credit.

They advance much more than what the collect from people
in the form of deposits.

Through the process of credit creation, commercial banks

provide finance to all sectors of the economy thus making
them more developed than before.

Credit Creation

The basis of credit money is the bank

deposits.

The bank deposits are of two kinds viz.,

Primary deposits, and

Derivative deposits

Primary Deposits

Primary deposits arise or formed when cash or cheque is

deposited by customers.

When a person deposits money or cheque, the bank will

credit his account.

The customer is free to withdraw the amount whenever

he wants by cheques.

These deposits are called primary deposits or cash

deposits.

Derivative Deposits

Bank deposits also arise when a loan is granted or when a

bank discounts a bill or purchase government securities.

Deposits which arise on account of granting loan or

purchase of assets by a bank are called derivative
deposits.

Since the bank play an active role in the creation of such

deposits, they are also known as active deposits.

Credit Creation

When the bank buys government securities, it does not pay

the purchase price at once in cash.

It simply credits the account of the government with the

purchase price.

The government is free to withdraw the amount whenever it

wants by cheque

The power of commercial banks to expand deposits through

loans, advances and investments is known as credit
creation.

Process of Credit Creation

The banking system as a whole can create credit which is

several times more than the original increase in the deposits
of a bank. This process is called the multiple-expansion or
multiple-creation of credit.

Similarly, if there is withdrawal from any one bank, it leads to

the process of multiple-contraction of credit.

The process of multiple credit-expansion can be illustrated

by assuming

The existence of a number of banks, A, B, C etc., each with different

sets of depositors.

Every bank has to keep 10% of cash reserves, according to law, and,

A new deposit of Rs. 1,000 has been made with bank A to start with.

Suppose, a person deposits Rs. 1,000 cash in Bank A. As a

result, the deposits of bank A increase by Rs. 1,000 and cash
also increases by Rs. 1,000. The balance sheet of the bank is
as fallows:

Suppose bank A lends Rs. 900 to X , Under the double entry

system, the amount of Rs. 1,000 is shown on both sides.

Suppose X purchase goods of the value of Rs. 900 from Y

and pay cash.

Y deposits the amount with Bank B.

The deposits of Bank B now increase by Rs. 900 and its cash
also increases by Rs. 900. After keeping a cash reserve of Rs.
90, Bank B is free to lend the balance of Rs. 810 to any one.

Suppose bank B lends Rs. 810 to Z, who uses the amount to

pay off his creditors. The balance sheet of bank B will be as
follows:

Suppose Z purchases goods of the value of Rs. 810 from S

and pays the amount.

S deposits the amount of Rs. 810 in bank C.

Bank C now keeps 10% as reserve (Rs. 81) and lends Rs. 729
to a merchant. The balance sheet of bank C will be as
follows:

Thus looking at the banking system as a whole, the position

will be as follow

Limitation on Credit Creation

Amount of Cash

Cash Reserve Ratio

The Banking Habits of the People

Nature of Business Conditions in the Economy

Leakages in Credit-Creation

Sound Securities

Liquidity Preference

Monetary Policy of the Central Bank

Credit control

Credit Control is an important tool used by the Reserve Bank

of India, a major weapon of the monetary policy used to
control the demand and supply of money (liquidity) in the
economy.

Why Credit Control is required

To encourage the overall growth of the priority sector i.e.

those sectors of the economy which is recognized by the
government as prioritized

To keep a check over the channelization of credit so that

credit is not delivered for undesirable purposes.

To achieve the objective of controlling Inflation as well as

Deflation.

To boost the economy by facilitating the flow of adequate

volume of bank credit to different sectors.

Methods of Credit Control

(1) Qualitative Method

(2) Quantitative Method:

Qualitative Method

By qualitative methods means the control or management of

the uses of bank credit or manner of channelizing of cash
and credit in the economy. Tools used under this method are:
Marginal

Requirement
Rationing of credit
Publicity
Direct Action
Moral Suasion

Marginal Requirement:

Marginal Requirement of loan can be increased or decreased

to control the flow of credit

for e.g. a person mortgages his property worth Rs.

1,00,000 against loan. The bank will give loan of Rs. 80,000
only. The marginal requirement here is 20%. In case the flow
of credit has to be increased, the marginal requirement will
be lowered.

Rationing of credit:

Under this method there is a maximum limit to loans and

advances that can be made, which the commercial banks
cannot exceed.

Publicity

RBI uses media for the publicity of its views on the current
market condition and its directions that will be required to be
implemented by the commercial banks to control the unrest.

Direct Action:

Under the banking regulation Act, the central bank has the
authority to take strict action against any of the commercial
banks that refuses to obey the directions given by Reserve
Bank of India.

Moral Suasion:

This method is also known as Moral Persuasion as the

method that the Reserve Bank of India, being the apex bank
uses here, is that of persuading the commercial banks to
follow its directions/orders on the flow of credit.

(2) Quantitative Method

By Quantitative Credit Control we mean the control of the

total quantity of credit. Different tools used under this
method are:
Bank

Rate
Open Market Operations
Repo Rates and Reverse Repo Rates
Cash Reserve Ratio
Statutory Liquidity Ratio
Deployment of Credit

Bank Rate:

Bank Rate also known as the Discount Rate is the official

minimum rate at which the Central Bank of the country is
ready to rediscount approved bills of exchange or lend on
approved securities.

Current bank rate is 7.75%

Open Market Operations:

Open Market Operations indicate the buying/selling of government

securities in the open market to balance the money supply in the
economy.

During inflation, RBI sells the government securities to the commercial

banks and other financial institution.

This reduces their cash lending and credit creation capacities. Thus,
Inflation can be controlled.

During recessions, RBI purchases government securities from commercial

banks and other financial institution.

This leaves them with more cash balances for lending and increases their
credit creation capacities. Thus, recession can be overcome.

Repo Rates and Reverse Repo Rates:

Repo is a swap deal involving immediate sale of securities and a

simultaneous re purchase of those securities at a future date at a
predetermined price.

Commercial banks and financial institution also park their funds

with RBI at a certain rate, this rate is called the Reverse Repo Rate.

Repo rates and Reverse repo rate used by RBI to make liquidity
adjustments in the market.

Current repo rate is 6.75% and reverse repo rate is 5.75%

Cash Reserve Ratio:

The money supply in the economy is influenced by the cash reserve ratio.

It is the ratio of a banks time and demand liabilities to be kept in reserve

with the RBI.

A high CRR reduces the flow of money in the economy and is used to
control inflation.

A low CRR increases the flow of money and is used to overcome

recession.

Current CRR rate is 4%

Statutory Liquidity Ratio:

Under SLR, banks have to invest a certain percentage of its

time and demand liabilities in Government approved
securities.

The reduction in SLR enhances the liquidity of commercial

banks.

Current SLR rate is 21.5%

Deployment of Credit:

The RBI has taken various measures to deploy credit in

different of the economy.

The certain percentage of bank credit has been fixed for

various sectors like agriculture, export, etc.