Commercial banks “create” credit through a process known as credit creation. Credit creation is definedas a process which commercial banks advance loans from deposits net of a statutory cash ratio requirement. This involves lending out money (from deposits) at an interest. This is because banks know from experience that only a fraction of its deposits will be demanded in cash at any particular time. Thus, the ability of banks to create deposit money depends on the fact that bank deposits need to be only fractionally backed notes and coins.
Because banks do not need to keep 100 percent reserves, they can use some of the money deposited to purchase income-yielding investments. The multiple expansion of credit arises from the re-deposit (created deposit) of money which has been borrowed. Nevertheless, banks cannot distinguish between
their initial deposits and created deposits.
Assuming a 10 percent cash ratio, banks are then able to repeat the process of lending out ninetenths and retaining one-tenths.
In a more realistic situation, what is usually found is where the bank receiving the new deposit is one of several independent banks. Thus, the bank will not seek immediate expansion of deposits to the number of times the cash ratio extending loans. To be taken into account is the fact that borrowers will use
the money (credit) advanced to them to pay for goods and services or repay debts; they will therefore be writing cheques out to other individuals who may have accounts in other banks. The bank can thus expect to lose cash to other banks. Either the borrowers will withdraw cash directly, with which to pay
individuals who then deposit this cash with other banks, or if they pay cheque these cheques will be deposited with other banks, and the other banks themselves present them for cash at the first bank.
The amount of credit that banks can make is largely subject to the variable reserve requirement (cash and liquidity ratios) which shows the relationship between the cash/reserve assets retained against total liabilities
Some other limitations to credit creation may be way of:
- The availability (supply) of collateral security – bank credit is largely in form of secured loan that is, banks have to take something in return, such as title deeds, an insurance policy or bill of exchange, as a security in case the loan is not repaid. The availability of such assets large influence (through the
intermediary of demand) the ability of banks to make loans.
- Monetary authority’s (central bank’s) intervention through such other requirements as the deposit protection fund (DPF) and the sale of treasury bills (TBS) at high interest return. Speculators in the stock market will then invest more in such securities than they save, thereconstraining the ability
of commercial banks to make more credit.
- Nature of political and economic atmosphere and thus the level of savings – in case of insecurity and exchange rate instability, for instance, the tendency is for people to withdraw large amounts of money and banking it elsewhere, most likely in foreign accounts; potential savers will again be discouraged the impact of inflation. This situation is an example of an election period such as Kenya’s (1197) where there are frequent calls for comprehensive political and economic reforms.
- Inefficient credit management commercial banks themselves – lending on grounds which are not purely on business terms may lead to large amounts of bad debts. This reduces the profitability and additional lending money. In fact (some) banks have been known to increase their base lending rates in order to compensate for he debts written off. The effect being a reduction in demand for credit which is again constraining on the credit creation process.