Explain the process of credit creation.
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Credit Creation is explained by taking an imaginary but relevant example.
Banks are responsible for accepting deposits and creating credit for the borrowers. Banks keep a part of deposits as reserves(LRR) which is legally compulsory. And the rest is given out as loans by opening a account in which this amount is deposited, the interest from these loans become income for banks. For example: banks receive ₹1000 as initial deposit and keep 20% as cash reserve i.e ₹800 as loans and ₹200 as LRR. Then ₹800 is credited in new account for loan, and when used for payment by borrower comes back to bank. So, similar to the previous stage, of the ₹800 deposit ₹160(20% of ₹900) is kept as reserve and ₹640 as loans. In third stage, from the ₹640, ₹512 will be given out as loans and ₹128 as reserves. This process continues and deposits keeps on increasing by 80% of last round, and reserves also increases by 80% of last round. This process comes to an end when total cash reserves equals to initial deposit, that is when cash reserves=₹1000, and banks will be able to create total deposits of ₹5000 with initial deposit of ₹1000. Thus, it helps in increased lending by banks, investment and thus income.
Banks are responsible for accepting deposits and creating credit for the borrowers. Banks keep a part of deposits as reserves(LRR) which is legally compulsory. And the rest is given out as loans by opening a account in which this amount is deposited, the interest from these loans become income for banks. For example: banks receive ₹1000 as initial deposit and keep 20% as cash reserve i.e ₹800 as loans and ₹200 as LRR. Then ₹800 is credited in new account for loan, and when used for payment by borrower comes back to bank. So, similar to the previous stage, of the ₹800 deposit ₹160(20% of ₹900) is kept as reserve and ₹640 as loans. In third stage, from the ₹640, ₹512 will be given out as loans and ₹128 as reserves. This process continues and deposits keeps on increasing by 80% of last round, and reserves also increases by 80% of last round. This process comes to an end when total cash reserves equals to initial deposit, that is when cash reserves=₹1000, and banks will be able to create total deposits of ₹5000 with initial deposit of ₹1000. Thus, it helps in increased lending by banks, investment and thus income.
The process of credit creation is primarily done by the commercial banks as it is one of the most important processes that facilitate the economic growth of a nation. Credit creation refers to the practice in which banks lend money to the borrowers out of their deposits after keeping aside a part of it as Legal Reserve Ratio (LRR).
The process of credit creation mainly involves the following steps:
1. A customer deposits his savings with the bank as a savings account or deposit (RD or FD).
2. The bank keeps aside a part of it in a prescribed ratio (i.e. LRR), which is determined by the Central Bank (RBI).
3. The bank, then, lends the remaining money as loan to a third person at a predetermined rate of interest and mutually agreed terms and conditions.
4. The borrower deposits that money into his/her account in some other bank which becomes a deposit for that bank and this process continues again.
This process keeps on moving which ultimately leads to circular flow of money as deposits and loans in banking sector. In this way, the process of credit creation is done by the commercial banks in a country.
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