Credit Creation by Commercial Banks: Process & Limitations.

In this article we have Explained the process of credit creation and limitationsby commercial banks

Introduction:

Credit creation by commercial banks is an important aspect of the monetary system. Commercial banks create credit by lending to customers, which is a process that has a multiplier effect on the money supply. The process of credit creation by commercial banks can be explained through the money multiplier model, which shows how an initial injection of money into the banking system can lead to a multiple expansion of the money supply.

However, while credit creation by commercial banks can be beneficial in promoting economic growth, it also has its limitations. These limitations include the need to maintain liquidity, the risk of credit default, and the impact on interest rates.

In this essay, I will explain the process of credit creation by commercial banks and discuss their limitations in detail.

Process of Credit Creation by Commercial Banks:

The process of credit creation by commercial banks can be explained through the money multiplier model, which shows how an initial injection of money into the banking system can lead to a multiple expansion of the money supply.

When a commercial bank receives a deposit, it is required to hold a certain percentage of that deposit as reserves. This is known as the reserve ratio or the reserve requirement. The reserve ratio is set by the central bank and varies by country and economic conditions. For example, in the United States, the reserve ratio is currently set at 10%.

The remaining portion of the deposit can be used by the bank for lending purposes. When a bank lends money, it creates a new deposit for the borrower. This deposit can be used by the borrower to make purchases or pay off debts, and it can also be used by other customers of the bank to withdraw cash or make payments. This creates a multiplier effect on the money supply, as the same initial deposit can be used multiple times.

For example, suppose a customer deposits $1,000 into a commercial bank. If the reserve ratio is 10%, the bank is required to hold $100 in reserves and can use the remaining $900 for lending purposes. If the bank lends $900 to a borrower, the borrower now has a new deposit of $900, which can be used by the borrower or other customers of the bank. If the borrower spends $700 and the recipient of that payment deposits the $700 into their account at the same bank, the bank now has an additional $700 in deposits, which can be used for lending purposes. This process can continue, with each deposit creating new deposits, and each new deposit being used for lending purposes, resulting in a multiple expansion of the money supply.

Limitations of Credit Creation by Commercial Banks:

While credit creation by commercial banks can be beneficial in promoting economic growth, it also has its limitations. These limitations include the need to maintain liquidity, the risk of credit default, and the impact on interest rates.

Need to Maintain Liquidity:

One of the main limitations of credit creation by commercial banks is the need to maintain liquidity. Liquidity refers to the ability of a bank to meet its obligations as they become due. Banks need to maintain a certain level of liquidity to ensure that they can meet withdrawals by depositors and make payments to other banks and financial institutions.

If a bank lends too much money and does not maintain sufficient reserves, it may not be able to meet its obligations in the event of a financial crisis or a sudden increase in withdrawals by depositors. This can lead to a run on the bank, where depositors withdraw their funds in a panic, causing the bank to become insolvent.

To avoid this scenario, banks are required to maintain a certain level of reserves and are subject to regulatory oversight by central banks and other regulatory agencies. Banks are also required to conduct stress tests to assess their ability to withstand adverse economic conditions.

Risk of Credit Default:

Another limitation of credit creation by commercial banks is the risk of credit default. When a borrower is unable to repay their loan, it results in a default. This can happen due to a variety of reasons, including economic downturns, job loss, or unexpected expenses.

Defaults can be costly for banks, as they may have to write off the loan as a loss and may also have to incur legal fees and other costs associated with recovery of the loan. In extreme cases, a high level of defaults can lead to the insolvency of the bank.

To manage the risk of credit default, banks use various risk management tools, such as credit scoring, collateral requirements, and loan covenants. They also diversify their loan portfolio to minimize the risk of losses due to defaults in a particular sector or industry.

Impact on Interest Rates:

Credit creation by commercial banks can also have an impact on interest rates. When banks increase their lending, it results in an increase in the money supply, which can lead to inflationary pressures. To counteract these pressures, central banks may increase interest rates to reduce borrowing and slow down the growth of the money supply.

On the other hand, if banks reduce their lending, it can result in a decrease in the money supply, which can lead to deflationary pressures. To counteract these pressures, central banks may reduce interest rates to encourage borrowing and stimulate economic growth.

Conclusion:

In conclusion, credit creation by commercial banks is an important aspect of the monetary system, as it can promote economic growth and support the functioning of the financial system. However, it also has its limitations, such as the need to maintain liquidity, the risk of credit default, and the impact on interest rates. To manage these limitations, banks use various risk management tools and are subject to regulatory oversight by central banks and other regulatory agencies.