There are two ways in which a bank creates credit:
(i) By advancing loans on the cash credit basis or by an overdraft arrangement;
(ii) By purchasing securities and paying for them with its own cheques.
In both these cases, deposits are created (or credit is created for the borrower), and the credit of the bank is embodied in a definite transaction. In all, a very small cash reserve is kept by the bank to meet the obligations arising out of these transactions, and the credit aggregates to a very big amount.
Let us see the actual process. Suppose a customer deposits Rs. 1,000 in a bank. The bank has to pay him interest; therefore the bank must seek a safe and profitable investment for this amount. That is, it must lend it to somebody in order to earn interest. But this amount is not actually paid out to the borrowers; it is retained by the bank to meet its obligations, i.e., to pay to those of its depositors who need cash, and draw cheques for the purpose.
The banker’s experience tells him that for this purpose only a certain percentage of cash reserve to total liabilities need be kept. In countries like Great Britain, they keep even less than lb per cent. The ratio of cash to liabilities is higher in countries like India where banking habit has yet to develop fully.
Suppose the bank in which a depositor has deposited Rs. 1,000 keeps 20 per Cent-cash reserve to meet the demand of depositors. This means that, as soon as the bank has received a deposit of Rs. 1,000, it will, make up its mind to advance loans up- to the amount of Rs. 5,000 (only one-fifth reserve is kept). When, therefore, a businessman comes to the bank with a request for a loan of Rs. 5,000, he may be sure of being granted accommodation to this extent, provided, of course, his credit is good.
The bank lends Rs. 5,000 although it has only Rs. 1,000 in cash. It is here that credit comes in. This transaction is rendered possible, because the borrower is not given the loan in cash; only an account is opened in his name (if he has not one already), and the amount is credited to that account. He is simply given a cheque book, i.e., the right to draw cheques as and when he needs money up to the amount of the loan.
Even if the borrower withdraws cash, it may be deposited in another bank, for businessmen do not raise funds to keep them locked up in a cash box but to run their business and to make payments to their creditors. When this particular businessman issues cheques on this bank to pay his creditors, these cheques are passed on by them to their own banks, where the amount is deposited in their account. Cash is seldom withdrawn. The banks adjust their mutual obligations through a system of bank clearing. Thus, the bank has succeeded in creating a credit of Rs. 5,000 against a cash reserve of Rs. 1,000.
But the process of credit creation does not stop here. The banks generally keep their spare cash in the Central Bank. A portion of Rs. 1,000, therefore, is deposited in the Central Bank, which, in its turn, uses it as a basis for similarly creating further credit.
Just as the banks go on creating credit (i.e., advancing loans on cash credit) all the time relying on their cash balances with the Central Bank, in the same manner the branch banks go on accommodating their local customers relying on the resources of the head office. The movement of credit creation thus goes apace. This is one way of creating credit.
The second way of creating credit is very simple. The bank can purchase securities without paying any cash. It issues its own cheque to pay the purchase – price. The cheque is deposited in this bank or some other bank and the small cash reserve which the bank keeps is sufficient to meet an obligation arising from this transaction too. It is thus that on a small cash foundation a vast superstructure of credit is built up.