Credit creation

Credit Creation :
The main source of funds, which is available to commercial banks, is in the form of deposits from the public.

Primary Deposits :
Primary deposits are also known as cash deposits. Such deposits refer to money deposited by the people in the form of cash with the banks. These deposits are withdrawable by the depositors.
A part of these deposits are kept by the bank, to meet the demand for cash of the depositor. This is termed as minimum cash reserves. The banks are able to do with a very small reserve because all depositors do not withdraw money at the same time.


Secondary/Derivative Deposits :
The balance over the minimum cash reserves, which is used by the banks to create credit by way of providing loans is known as derivative deposit. or Derivative deposit is a deposit which is left over after deducting cash reserve from primary deposits. When a bank grants loan to a borrower, bank opens a deposit account in the name of the borrower. Borrower can withdraw money from this account by means of cheque.
If a bank purchases securities from a seller, it opens an account in the name of the seller who can withdraw from it.
When the borrower withdraws money from his loan account by a cheque, it is deposited by the payee in some other bank. These banks again create credit on the basis of fresh deposits received after keeping the required reserves. In this way, commercial banks create credit money, which is the part of total money supply.
For example, let us suppose that every bank has to keep 20%, of its deposits as cash reserve and advances loans from 80% of its deposits. Bank 'A' receives a primary deposit of `10,000/- retains, 20% as cash reserve and lends ` 8,000/- to a businessman who deposits it in bank `B'. The bank 'B' would lend ` 6,400/- after retaining ` 1,600/- The amount of ` 6400/- is deposited in bank 'C', which retains Rs. 1,280/- and lends ` 5,120/-. The amount ` 5120/- is deposited in bank 'D'. The bank D would lend ` 4096/- after retaining ` 1024/-. This process ends at the stage where the subsequent banks receive too small amount as primary deposit to advance any loans from it. The following table summaries this process.
Banks
Primary Deposit
Reserves
Secondary Deposits
Loans
A
10000
2000
8000
8000
B
8000
1600
6400
6400
C
6400
1280
5120
5120
D
5120
1024
4096
4096

Total credit created can be arrived at with the help of the following simple formula.
Total Credit Created = A X 1/R
'A' is the original primary deposit and
'R' is the Reserve Ratio.
1 is ratio of primary deposits.
Cash reserve ratio is 20%. For example
` 10000 X 1/20% = ` 10,000 X 1
20
100
= ` 10,000 X 1 X 100 / 20
= ` 10,000 X 10 /2
= ` 100,000/2
= ` 50,000/-