Banking & Monetary Policy

Credit Creation is explained by taking an imaginary but relevant example.

1. As is the case in the real world, we take a situation of multiple banking systems. We presume many commercial banks such as HDFC Bank, PNB, Axis Bank, etc. are in the country.
2. It is assumed that minimum legal cash reserve ratio is 20%. Thus, each bank is required to keep 20% of its deposits in the form of cash reserves with it.

• Excess (over 20%) cash reserve is used in extending loans and advances.

1. One particular bank, say Axis Bank, receives a cash deposit of ₹100,000 from its customers.
2. Axis Bank keeps a cash reserve of ₹20,000 (20% of ₹100,000) and gives a loan of ₹80,000 (₹100,000 – 20,000 = ₹80,000) to one of its customers. This is the first round of credit creation.
3. This borrower uses the amount for purchasing goods from some trader. He pays by drawing a check on PNB. He will deposit this check in PNB to be collected from Axis Bank on his behalf. The whole amount is transferred to PNB.

• Since PNB is obliged to keep 20% as CRR, it keeps ₹16,000 with it and has an excess of ₹64,000. This is the second round of credit creation.
• In the third round, the businessman uses this amount to purchase from a manufacturer by issuing a check. The manufacturer has his account in BOB, he will deposit this check and get the money transferred to his bank account. In the next round, BOB will keep ₹12,800 as CRR and transfer the remaining ₹51,200. This process goes on.