Technique of Credit Creation by Commercial Banks: Bank credit refers to bank loans and advances. Money is said to be created when the banks, through their lending activities, make a net addition to the total supply of money in the economy. Likewise, money is said to be destroyed when the loans are repaid by the borrowers to the banks and consequently the credit already created by the banks is wiped out in the process. Banks have the power to expand or contract demand deposits and they exercise this power through granting more or less loans and advances and acquiring other assets. This power of commercial bank to create deposits through expanding their loans and advances is known as credit creation.
Primary/Passive Deposit and Derived/Active Deposit: The modern banks create deposits in two ways. They are primary deposit and derived deposit. When a customer gives cash to the bank and the bank creates a book debt in his name called a deposit, it is known as a “primary deposit’. But when such a deposit is created, without there being any prior payment of equivalent cash to the bank, it is called a ‘derived deposit’.
Primary 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”.
Credit Creation literally means the multiplication of loans and advances. Every loan creates its own deposits. Central Bank insists the banks to maintain a ratio between the total deposits they create and the cash in their possession.
For the purpose of understanding, it is assumed that all banks are obliged to keep the ratio between cash and its deposits at a minimum of 20 percent.
1. The banks do not keep any excess reserves, in other words, it would exhaust possible avenues of income earning activities like giving loans etc. up to the maximum extent after attaining the minimum cash reserves.
