Credit creation by the Commercial Banks

The Central bank is the first and the commercial banks are the second most important sources of money supply in the form of currency in circulation. The money that commercial banks supply is called credit money.  The process of 'Credit Creation' begins with commercial banks lending money out of primary deposits. Primary deposits are those deposits that are deposited in banks. In fact, banks cannot lend the entire primary deposits as they are required to maintain a certain proportion of primary deposits in the form of reserves with the Central Bank. After maintaining the required reserves, the bank can lend the remaining portion of primary deposits. Derivative deposits are created by the bank in a more active manner by opening a deposit account in the name of the person who comes to the bank to borrow funds from it, they are known as active deposits. 

Assumptions:

i.  There are many banks say, X, Y, Z, etc., in the banking system.

ii. The Cash reserve ratio (CRR) is fixed by the Central bank at 10%.

iii. The first bank has Rs. 1000 as deposits.

iv. The loan amount drawn by the customer of one bank is deposited in full in the second bank, and that of the second bank into the third bank, and so on.

v. Each bank starts with the initial deposit which is deposited by the debtor of the other bank.

To begin with, let us suppose that customer A makes a deposit of Rs. 1000 in bank X. Bank "X" is required to maintain a Cash Reserve Requirement of 10% which is Rs.100. The bank has now lendable funds of Rs. 900. Let the Bank "X" lend Rs. 900 to a borrower; say B. The method of lending is the same that is bank X opens an account in the name of the borrower cheque for the loan amount. At the end of the process of deposits & lending, the balance sheet of the bank is given below:-

Balance Sheet of Bank "X":

Liabilities	Amount	Assets	Amount
Primary deposits	1000	Cash Received	1000
CRR@10%	100	CRR@10%	100
Derivative deposits	900	Loan to "B"	900
Total	1000	Total	1000

The loan of Rs. 900 is deposited by the customer in bank Y whose balance sheet is shown in the following table. Bank Y starts with a deposit of Rs. 900, keeps 10% of it or RS. 90 as cash in reserve. Bank Y has Rs. 810 as excess reserves which it lends to say, Mr C, thereby creating new deposits.

Balance Sheet of Bank "Y":

Liabilities	Amount	Assets	Amount
Primary deposits	900	Cash Received	900
CRR@10%	90	CRR@10%	90
Derivative deposits	810	Loan to "C"	810
Total	900	Total	900

The loan of Rs. 810 is deposited by the customer of bank Y into bank Z. The balance sheet of bank Z is shown in the following table:

Balance Sheet of Bank "Z":

Liabilities	Amount	Assets	Amount
Primary deposits	810	Cash Received	810
CRR@10%	81	CRR@10%	81
Derivative deposits	729	Loan to "B"	729
Total	810	Total	810

The process of deposits and credit creation will continue until the reserve with the banks is reduced to zero. The process of deposit & credit creation by the banking system is presented in the consolidated balance sheet of all banks are as under:-

The combined Balance sheet of All Banks:

Bank	Primary  Deposits	Cash reserve ratio @ 10%	Excess Reserve/Loans	Total
Bank X	1000	100	900	1000
Bank Y	900	90	810	900
Bank Z	810	81	729	810
Other banks	7290	729	6561	7290
Bank ‘n’	00	00	00	00
Total	10000	1000	9000	10000

It can be seen from the combined balance sheet that primary deposits of Rs. 1000 in a bank X leads to the creation of the total deposit of Rs. 10,000. The combined balance sheet also shows that the banks have created a total credit of Rs. 9,000 and maintained a total cash reserve of Rs.1000 which equals the primary deposits. The total deposit created by the commercial banks constitutes the money supply by the banks.

Conclusion: 

To conclude, we can say that credit creation by banks is one of the important & only sources to generate income. And when the reserve requirement is increased by the central bank it would directly affect the credit creation by the bank because then the lendable funds with the bank decreases and vice versa. 

Additional note: 

Derivative deposits: These consist of deposits created by the banks in the process of granting credit. The loan sanctions and credited to the accounts of the borrowers create new deposits. Derivative or active deposits are created by the bank by opening a deposit account in the name of the person concerned who contacts the bank to borrow money. Then the bank plays an active role in the creation of such deposits. This type of dealings is known as active deposit.