Explain the process of credit creation in banking and multibanking in an economy and what are the limitationsofcredit creations
Answers
Answer:
Demand deposits are an important constituent of money supply and the expansion of demand deposits means the expansion of money supply. The entire structure of banking is based on credit. Credit basically means getting the purchasing power now and promising to pay at some time in the future. Bank credit means bank loans and advances.
A bank keeps a certain part of its deposits as a minimum reserve to meet the demands of its depositors and lends out the remaining to earn income. The loan is credited to the account of the borrower. Every bank loan creates an equivalent deposit in the bank. Therefore, credit creation means expansion of bank deposits.
Limitations of Credit Creation
While banks would prefer an unlimited capacity for creating credit to increase profits, there are many limitations. These limitations make the process of creating credit non-profitable. Therefore, a bank continues to create additional credit as long as:
There is a negligible chance of the loans turning into bad debts
The interest rate that banks charge on loans and advances is greater than the interest that the bank gives to depositors for the money deposited in the bank.
Hence, we can say that the limitations of credit creation operate through shifts in the balance between liquidity and profitability. The factors that affect the creation of credit are:
The capacity of banks to create credit.
The willingness of the banks to create credit
Also, the demand for credit in the market.
Capacity to create credit is a matter of:
The availability of cash deposits with banks
The factors which determine their cash deposit ratio
As regards the demand for credit:
The demand must exist in the market
Creditworthy borrowers (to avoid bad debts)
The amount of loan granted should not exceed the paying capacity of the borrower
Leakages
If the banks are unwilling to utilize their surplus funds for granting loans, then the economy is headed towards recession
If the public withdraws cash and holds it with themselves, then it reduces the bank’s power to create creation.
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