Credit Creation and Credit Control: Concept, Limitations, Methods

  • Post last modified:16/01/2022
  • Reading time:12 mins read

What is Credit Creation?

A bank may receive interest simply by permitting a customer to overdraw their account or by purchasing securities and having for them with its own cheques, thus, increasing the total bank drafts. One should remember that a single bank creates very little credit. It is a whole banking system that can expand credit.

Credit creation is one of the essential functions of a commercial bank. The term credit can be defined in both narrow and broad senses. In broad terms, credit is finance that is made available by one party – lender, seller, or shareholder/owner to another party borrower, buyer, or a business firm.

The former could be a pure lender a financial institution or a private moneylender, a seller/supplier of goods on the promise of the buyer to make payment in future, or a shareholder/owner of a firm making funds available to the firm recognized as a separate entity.

More commonly, the term credit is practised in a narrow sense that is only for debt finance. Credit is simply the opposite of debt; both are created instantly by the same contract. It is a special sort of exchange transaction involving future payments, interest added to debt at its time value.

This view of credit lies at the heart of modern commercial banking. The commercial banks create multiple expansions of their bank deposits and due to this, these are called the factories of credit.


Concept of Credit Creation

A bank deposit is a basis for credit money. The bank deposits are of two kinds viz:

  1. Primary Deposits
  2. Derivative Deposits

Primary Deposits

Primary deposits arise or spring up when cash or cheque is deposited by customers. When a person deposits cash or cheque, the bank will credit his account. The customer is free to withdraw the amount whenever he wants through a cheque.

These deposits are called “primary deposits” or “cash deposits.” It is out of these primary deposits that the banks provide loans and advances to their customers. The initiative is taken by the customers themselves.

In this case, the bank plays a passive role. So, these deposits are also called “passive deposits.” These deposits merely convert currency money into deposit money. They do not create money. They do not make any net addition to the stock of money. In other words, there is no increase in the supply of money.

Derivative Deposits

Bank deposits also arise when a loan is granted or when a bank discounts a bill or purchases government securities. Deposits that arise on account of granting a loan or purchase of assets by a bank are called “derivative deposits.” Since the bank plays an active role in the creation of such deposits, they are also known as “active deposits.”

When the banker sanctions a loan to a customer, a deposit account is opened in the name of the customer and the sum is credited to his account. No cash is paid by the bank to the banker for doing so. The customer is free to withdraw the amount whenever he requires by the medium of the cheque.

Thus, the banker lends money in the form of deposit credit. The creation of a derivative deposit results in a net increase in the total supply of money in the economy; Hartly Withers says “every loan creates a deposit.” It may also be said “loans make deposits” or “loans create deposits.” It is rightly said that “deposits are the children of loans, and credit is the creation of bank clerk’s pen.”


Limitations of Credit Creation

Though commercial banks have the power to create credit, they possess limited powers. Certain factors affect the process of credit creation. They are termed as limitations to credit creation by commercial banks. The limitations of credit creation by commercial banks are as follows:

  1. Amount of Deposit
  2. Cash Reserve Ratio (CRR)
  3. Banking Habits of People
  4. Supply of Securities
  5. The Willingness of People to Borrow
  6. Monetary Policy of Central Bank
  7. External Drain
  8. Uniform Policy

Amount of Deposit

The most significant factor which determines credit creation is the number of deposits made by the depositors. Higher is the number of deposits; greater is the supply of credit and vice versa.

Cash Reserve Ratio (CRR)

There exists an indirect relationship between Credit Creation and Cash Reserve Ratio. Higher is the Cash Reserve Ratio more will be the reserves to be maintained and less credit will be created by banks. The CRR is fixed by the RBI in India. It ranges from 3% to 15%.

Banking Habits of People

If the banking habits of the people are well-developed, then all of their transactions would be through banks, and this will lead to the expansion of credit and vice-versa.

Supply of Securities

Loans are sanctioned on the basis of the securities provided to the banks. If securities are available then the credit creation will be more and vice-versa.

The Willingness of People to Borrow

Commercial banks may have enough money to lend. Customers should be willing to borrow from the banks to facilitate credit creation. If they are willing to borrow, then the credit created by banks will be less.

Monetary Policy of Central Bank

While credit is created by commercial banks, it is controlled by the Central Bank. Credit control is one important function of the central bank. Central Bank uses various methods of Credit Control from time to time and thus influences the banks to expand or contract credit.

External Drain

External Drain refers to the withdrawal of cash from the banking system by the public. It lowers the reserves of the banks and limits credit creation.

Uniform Policy

If all the commercial banks follow a uniform policy related to CRR, then credit creation would be smooth. If some banks follow liberal and others follow a conservative one, then credit creation would be affected.

Thus, various limitations hinder the path of the ability of the banks to create credit. Still, one should not underestimate the significance of the credit creation function of the banks. This function has long-run implications on the functioning of the economy, particularly on the activities of the business. Bank credit acts as the oil which lubricates the wheels of the business machine.


What is Credit Control?

The chief objective of the Central bank is the regulation and control of the aggregate money supply, currency and credit in the economy. The Reserve Bank of India is the controller of the credit, i.e. it has the power to influence the volume of credit created by banks.

The banks have made use of both traditional and quantitative methods of credit control and selective or qualitative control.


Techniques of Credit Control

Several tools and techniques of credit control used by the Reserve Bank of India can be broadly categorized as:

Quantitative or General Methods

The tools used by the central bank to influence the volume of credit in totality in the banking system, without any regard for the use to which it is put, are called quantitative or general methods of credit control.

These methods govern the lending power of the financial sector of the whole economy and do not discriminate among the several spheres of the economy. The crucial quantitative methods of credit control are:

  1. Bank Rate Policy
  2. Open Market Operations
  3. Adjusting with CRR and SLR
  4. Lending Rate
  5. Repo Rate
  6. Reverse Repo Rate

Bank Rate Policy

The standard rate at which the central bank is ready to buy or rediscount bills of exchange or other commercial papers eligible for purchase under the provisions of the Act of RBI. Thus, the Reserve Bank of India rediscounts the first-class bills in the hands of commercial banks to furnish them with liquidity in case of need.

The bank rate is subjected to change from time to time in accordance with the economic stability and the credibility of the nation.

Open Market Operations

It means of enforcing monetary policy by which RBI controls the short term rate of interest and the supply of base money in an economy, and thus indirectly the total supply of money. In times of inflation, RBI sells securities to finish off the excess money in the market. Similarly, to increase the money supply, RBI purchases securities.

Adjusting with CRR and SLR

By adjusting the CRR (Cash Reserve Ratio) and SLR(Statutory Liquidity Ratio) which are short term tools to be used to shortly govern the cash and fund flow in the hands of the banks, people and government, the central bank of India regularly make necessary alterations in these rates. These variations in the rates will easily have larger control over the cash flow of the country.

  • CRR (Cash Reserve Ratio): All commercial banks are required to retain a certainamount of its deposits in cash with RBI. This percentage is called the cash reserveratio. The present CRR requirement is 4 per cent.

    This serves two purposes. Firstly,it ensures that a part of bank deposits is totally risk-free and secondly it enables RBIto control liquidity in the system, and thereby, inflation by tying their hands inlending money.

  • SLR (Statutory Liquidity Ratio): Indian banks are required to maintain 25 per cent oftheir time and demand liabilities in government securities and certain approvedsecurities. What SLR does is again restrict the bank’s leverage in lifting more moneyinto the economy by investing a part of their deposits in government securities as apart of their statutory liquidity ratio requirements.

Lending Rate

Lending rates can be defined as the ratios fixed by RBI to lend the money to the customers on the basis of those rates. The higher the rate of lending signifies the costlier credit to the customers.

The lower the rate of lending signifies the credit to the customers is less which will encourage the customers to borrow funds from the banks more that will facilitate the flow of more money in the hands of the public.

Repo Rate

Repo rate is the rate at which banks borrow funds from the central bank to fill the gap between the demand they are facing for providing loans to their customers and how much funds they have on hand to lend.

If the RBI wants to make it more costly for the banks to borrow money, it hikes the repo rate; similarly, if it wants to make it cheaper for banks to borrow money, it cuts the repo rate.

Reverse Repo Rate

The rate at which the Reserve Bank of India borrows money from the banks (or banks lend money to the RBI) is termed as the reverse repo rate. The RBI uses this instrument when it feels there are too many funds floating in the banking industry.

If the reverse repo rate is rising up, it means the RBI will borrow money from the bank and offer them a lucrative rate of interest. As a result, banks would prefer to keep their money with them (which is absolutely risk-free) in lieu of lending it out (this option comes with a certain amount of risk) to other customers.

Qualitative or Selective Methods

The tools used by RBI to govern the flows of credit into specific directions of the economy are called qualitative or selective methods of credit control.

Unlike the quantitative methods, which affect the total volume of credit, the qualitative methods affect the types of credit extended by the commercial banks; they affect the composition of credit rather than the size of credit in the economy.

The important qualitative or selective methods of credit control are:

  1. Marginal Requirements
  2. Regulation of Consumer Credit
  3. Credit Rationing
  4. Moral Suasion
  5. Direct Action
  6. Publicity

Marginal Requirements

Every commercial bank has to keep a margin whenever it provides loans against the security. It means that the amount of the loan is lower than the real value of the security. For example, the Actual value of the security is 100 and the amount of the loan is 85, therefore the margin requirement is 15%.

The central bank can increase or decrease the supply of money by altering the requirements of margin. For example: if the central bank wants to decrease the money supply it can do so by increasing the margin requirements. In this way amount of loans decreases.

Regulation of Consumer Credit

Consumer credit facility refers to the act of selling a consumer good on a credit basis to the customers. This tool is used by the government reserve bank of India to enforce certain regulations on the goods that are sold on credit.

If the central bank wants to increase the money supply it can do so by adopting a lenient policy about the credit for the purchase of consumer goods. Similarly, the central bank can cut the money supply by putting limitations on consumer credit.

Credit Rationing

The central bank uses credit rationing to fix the credit ceiling allowed for each and every commercial bank. The central bank fixes the credit limit for each commercial bank and does not give credit to them beyond that limit.

Whenever the RBI desires to cut the supply of money, it decreases the limit up to which it can give loans to the member banks. Likewise, the central bank can increase the money supply by increasing the credit limit.

Moral Suasion

In some cases, the central bank morally persuades or requests the commercial banks not to get involved in such economic activities which are unfavourable to the interest of the country. It regularly guides and proposes the member banks follow a specific policy for loans and abstain from giving loans for speculative purposes.

Direct Action

Direct action is the last option through which the central bank takes direct action against the bank which does not act in conformity with the policy of the Reserve Bank of India. In case of direct action, the central bank can impose fines and penalties and can deny giving out loans to the commercial bank. Such a type of force keeps commercial banks away from unsought credit activities.

Publicity

The central bank also publishes details concerning its policies and important information about assets and liabilities, credit and business situation etc. of commercial banks. This facilitates commercial banks as well as the general public to realize the monetary needs of the country.

Central bank discloses some of the important information about the commercial banks so that the people know about the several activities of commercial banks and can protect themselves from any potential loss in the future.


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