Before moving towards the topic we will first understand what banks are? Bank is an institution which receives funds from the public and gives loans and advances to those who need them. Here, in this topic we are particularly talking about creation of money by the commercial banks.
Commercial banks are those financial institutions which accept chequeable and non-chequeable deposits from the public and offers different kind of loans. The primary function of these commercial banks are acceptance of deposits, advancement of loans, credit creation, transfer of funds, overdraft facility, discounting bills of exchange and agency functions (fund transfer, fund collection etc). Commercial banks create money by the multiplication of loans and advances. They have the capacity to generate credit through demand deposits (demand deposits is the amount the depositor deposit in the bank). These demand deposits make credit more than the initial deposits. Let’s understand this money creation process by an example:
Suppose a depositor deposits Rs 20,000 in his saving account of a bank ABC, which is the demand deposit of the bank. The banks maintain a minimum cash reserve of 10% of the demand deposit and lend rest of the amount (19,000) in the form of credit to other customers. This creates deposits for the bank ABC. With the cash reserve of 10%, the credit creation is worth RS 20,000. And thus the money supply in the economy will increase by the time of credit multiplier (fraction by which commercial banks would be able to multiply money).
The commercial banks also increase the flow of money in an economy by credit creation (granting loans and advances made by banks to public). The banks issues loans from their cash reserves with the historical experience that all depositors will not withdraw their funds at the same time. In this way commercial banks create credit many more times than their cash reserves and contributes to increase money supply in economy. Every loan creates a deposit which directly multiplies the original bank deposit. Thus, banks are not merely purveyors of money but also they are the manufacturers of money too.
Although the commercial banks helps in creation of money and credit creation but they can’t extent it to as such level. In reality, there are some limitations due to which their power to create credit decreases and they are:
· Cash leakage.
In the process of expanding the credit there is some leakage in banking system means that the borrowers do not deposit the entire amount of sanctioned loans. Thus this will directly cause multiplier effect to become weaker.
· Public prefer more cash than cheque
The credit creation of commercial banks depends on the desire of public to hold cash. If public use more cash then cheque, the banks will left with smaller amount of credit deposit and consequently credit creation process will slow down.
· Business conditions
Credit creation depends on business conditions, If business conditions look unfavorable, people will take fewer loans and advances from commercial banks. Thus the total volume of money supply will be smaller.
CONCLUSION- Despite of having these limitations commercial banks create credit that help in increasing the supply of money in an economy. Thus, they are an important part of the economy. Not only do they provide consumers with an essential service but they also help create capital and liquidity in market. Their financial services thus help to make the overall economy more efficient.