An important function performed by the commercial banks is the creation of credit. The process of banking must be considered in terms of monetary flows, that is, continuous depositing and withdrawal of cash from the bank. It is only this activity which has enabled the bank to manufacture money. Therefore the banks are not only the purveyors of money but manufacturers of money.
Basis of Credit Creation
The basis of credit money is the bank deposits. The bank deposits are of two kinds viz.,
(1) Primary deposits
(2) Derivative deposits
Primary deposits arise or formed when cash or cheque is deposited by customers. When a person deposits money or cheque, the bank will credit his account.
The customer is free to withdraw the amount whenever he wants by cheques. These deposits are called “primary deposits” or “cash deposits.” It is out of these primary deposits that the bank makes loans and advances to its customers. The initiative is taken by the customers themselves. In this case, the role of the bank is passive.
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.
Bank deposits also arise when a loan is granted or when a bank discounts a bill or purchase government securities. Deposits which arise on account of granting loan or purchase of assets by a bank are called “derivative deposits.”
Since the bank play 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. The bank does not pay him cash.
The customer is free to withdraw the amount whenever he wants by cheques. Thus the banker lends money in the form of deposit credit.
The creation of a derivative deposit does result 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.”
Granting a loan is not the only method of creating deposit or credit. Deposits also arise when a bank discounts a bill or purchase government securities. When the bank buys government securities, it does not pay the purchase price at once in cash.
It simply credits the account of the government with the purchase price. The government is free to withdraw the amount whenever it wants by cheque.
Similarly, when a bank purchase a bill of exchange or discounts a bill of exchange, the proceeds of the bill of exchange is credited to the account of the seller and promises to pay the amount whenever he wants. Thus asset acquired by a bank creates an equivalent bank deposit.
It is perfectly correct to state that “bank loans create deposits.” The derivate deposits are regarded as bank money or credit. Thus the power of commercial banks to expand deposits through loans, advances and investments is known as “credit creation.”
Thus, credit creation implies multiplication of bank deposits. Credit creation may be defined as “the expansion of bank deposits through the process of more loans and advances and investments.”