ways by which commercial banks create credit or money and their problem

WAYS BY WHICH COMMERCIAL BANKS CREATE CREDIT OR MONEY            ways by which commercial banks create credit or money. Credit or money creation refers to the process whereby commercial banks make it possible for more deposits to be made through loans or overdrafts.

Bank lending in form or loan or overdraft increases the quantity of money in circulation, which in turn increases the purchasing power of the people.

This is because the bank credits the amount borrowed thereby creating new bank deposits. The total purchasing power increases by the amount loaned out. This is why it is said that bank lending creates credit or money.

Commercial banks can create money or credit in the following ways:

  •  By granting loans to members of the public and charging interest on them. By so doing more money is pumped into circulation and this increases the purchasing power of the people.
  •  By granting overdraft to customers having current account. This process of overdraft permits customers to draw money above the amount in their current account up to a certain limit and interest is charged on the overdraft.

  • (An overdraft is defined as the excess amount which a customer is allowed to draw over the amount he has in his current account). Commercial banks use current account as the basis for creating credit or money.

  •  Commercial banks are required by law to keep certain percentage of their deposit with the central bank known as cash ratio or liquidity ratio or cash reserve. This is done in order to protect customers’ accounts and prevent bank crisis.

When the percentage of the cash reserve is low, it will enable the commercial banks to give out loans and overdrafts thereby creating credit or money but when the percentage of cash reserve is high, commercial banks

will find it difficult to lend out money, Commercial banks can create credit or money by purchasing treasury bills from the government and by discounting bills of exchange.

It should be noted that for commercial banks to be able to create credit the following assumptions must be made.

 That no single bank can create credit except all the banks or the banking system is involved.

That no excess reserve exists.

 There must be no cash drain from the banks.

  •  That the banks invest only in loans, overdrafts and purchase of treasury bills from government.
  •  That there must be only one type of demand – demand deposit.

LIMITATIONS TO CREDIT CREATION BY COMMERCIAL BANKS

  •  Cash deposit ratio: The higher the legal reserve requirements, i.e. the higher the cash deposit ratio, the lower the ability of commercial banks to create money.
  •  Collateral security available: If collateral security is not available, banks will be scared of lending, hence the lower the volume of money created.
  •  Central bank’s restrictions: Central bank’s action to restrict lending, e.g. open market operation and directives can affect the ability of commercial banks to create money.
  •  Amount of cash drain from the banking system: The more the amount of cash drain from the banking system, the less the amount of cash available with banks, e.g. when people borrow money and spend it on consumption.
  •  Interest rate charged: The higher the interest rate charged by commercial banks, the lower the rate at which customers will take loans and consequently the lower the ability to create money and vice versa.
  •  Willingness of other banks to lend to the public: The higher the willingness of other banks to lend to the public, the greater the ability of commercial banks to create money.

7.  Willingness of the public to take bank loans: Commercial banks are able to create money

when the public are willing to take bank loans and overdrafts, i.e. existence of borrowers.

8.  Desire of the people to save: When people save, deposits are created and it is from these deposits that banks give out loans. So, the more people save, the more banks are able to create credit or money and vice versa.

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