Process of credit creation by commercial banks and how RBI regulates credit flow

The process of credit creation by commercial banks and how the RBI regulates this credit flow

This article is not from accounting, direct or indirect tax perspective. This deal with a general topic about how the credit is created by commercial banks in the economy and how the RBI monitors this credit creation.

Let us take an example to understand how credit creation is done by banks-

Let us assume that customer Mr.X deposits Rs.1,00,000/- in Bank of India(BOI) and let us assume that banks are required to keep 20% of deposits in the form of cash reserve to meet with various statutory obligation and to meet with the customers drawing from banks. It is very well known that all the deposits of customers would not be withdrawn on the same day (though now-a-days exceptions can arise) and the banks can estimate the amount required every day to meet its liabilities.

The balance sheet of BOI after the deposit would be as under-

The BOI is required to keep cash reserve of 20% of 1,00,000 i.e. Rs. 20,000/- and excess amount can be used for loan advancing. Now assume BOI advances a loan of Rs. 80,000 to a firm M/s ABC, who uses this to purchase some goods from M/s XYZ. M/s ABC gives a cheque of Rs.80,000 drawn on BOI to M/s XYZ. M/s XYZ deposits this cheque in State Bank of India (SBI). As a result the amount of Rs. 80,000/- is transferred by BOI to SBI. The final Balance Sheet of BOI is as under-

Now SBI has a deposit of Rs. 80,000 and it has to maintain a cash reserve of Rs. 16,000 (20% of 80,000) and can utilise Rs.64,000 to give loans. Now assume SBI gives a loan to M/s GHI for purchase of goods. M/s GHI issues a cheque drawn on SBI for Rs.64,000 to M/s JKL. M/s JKL then deposits this cheque in ICICI bank. Now ICICI bank has a deposit of Rs.64,000 and can advance loan of Rs.51,200 (80% of 64,000) to its customers. This process will go on until the minimum reserve limit is reached. Thus a deposit of Rs.1,00,000 in BOI has created deposit of Rs.1,00,000+80,000+64,000+51,200…… and is still going on. This is how banks create credit in the economy.

There are various factors which effect the amount of credit created by banks, the 3 major ones are-

1. Banking habits of people: If people have the habit of using cheque, DD, bills in their business over currency then banks have the ability to create more credit as money keeps rotating in the banking system. That is why banks in the advanced countries are able to create more credit. This is also one of the reason why the Modi government encourages digital mode of payment over the currency mode, apart from the reason of reducing the parallel economy.

2. Ratio of cash reserve to deposit: Banks are required to keep Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR). The smaller the amount of cash reserve the more will be the power of banks to create credit.

3. Monetary policies of the central Bank: The monetary policies of the Central Bank i.e. the Reserve Bank Of India (RBI) plays a huge role in effecting the ability of commercial banks to create credit. The RBI uses a number of methods to regulate the credit creation in the economy, some of them are: –

a. Bank Rate: It is the rate at which RBI gives loans to or rediscounts the bill of exchange of the commercial banks. This is also known as the repo-rate. The bank rate and the rate of interest charged by the commercial banks to its customer are inter-related. For example, in case of inflation when the RBI wants to contract the credit flow in the economy it increases the repo-rate. This would lead to an increase in the rate of interest charged by the commercial banks to the customers and thus higher interest outgo world reduce the amount borrowed by the customer from the banks. Thus reducing the cash available in the economy. And during recession the RBI would reduce the repo rate to increase the credit flow in the economy. This is evident from the recent RBI decision to reduce the repo-rate from 5.15% to 4.40%. This was required as the economy is entering into a recessionary phase due to COVID-19 impact world-wide.

b. Open Market operations: It refers to the sale and purchase of securities by the RBI in the money and capital markets. During inflation the RBI sells its securities. Buyer of the securities pays the amount by withdrawing their deposits from the banks. This reduces the cash holdings of the commercial banks and a reduction of cash reserve would reduce the loans and advances given by them and hence reduce the credit flow in the economy.

c. Cash Reserve Ratio: Commercial banks are required to keep a portion of the total deposits with the RBI as cash reserve. During inflation RBI increases the CRR and during recession RBI reduces it. It is for this reason that RBI has recently cut the CRR from 4% to 3% of net time and demand liabilities (NTDL), to counter the COVID related recession.

It is due to this process that in case one bank collapses, the entire banking chain is effected and this leads to cyclical effect of NPA’s. Hence it is important to maintain the financial health of banks to ensure there is no serious repercussion on the economy if banking system collapses.