The following points highlight the eleven major limitations of credit creation by commercial banks.
Some of the limitations are: 1. Cash Reserve Ratio 2. Availability of Adequate and Proper Securities 3. Keeping of Reserve with the Central Bank 4. Banking Habits of the People 5. Volume of Currency in Circulation and Others.
Limitation # 1. Cash Reserve Ratio:
The credit creation power of banks depends upon the amount of cash they possess.
The larger the cash, the larger the amount of credit that can be created by banks.
Thus, the bank’s power of creating credit is limited by the cash it possesses.
Limitation # 2. Availability of Adequate and Proper Securities:
If proper securities are not available with the public, a bank cannot create credit. As Crowther has written—”the bank does not create money out of thin air, it transmutes other forms of wealth into money.”
Limitation # 3. Keeping of Reserve with the Central Bank:
Every affiliated and attached bank has to keep certain reserves with the Central Bank of the country. The Central Bank keeps on changing the percentages of these reserves from time to time. When the Central Bank increases the percentages of these reserves, then the power of the commercial banks to create credit is reduced in the same proportion.
On the other-hand if the Central Bank reduces the percentage of these reserves, the power of the Commercial Banks to create credit is increased in the same proportion.
Limitation # 4. Banking Habits of the People:
The banking habits of the people are an important factor which governs the power of credit creation on the part of banks. If people are not in the habit of using cheques, the grant of loans will lead to the withdrawal of cash from the credit creation stream of the banking system. This reduces the power of banks to create credit to the desired level.
Limitation # 5. Volume of Currency in Circulation:
Volume of currency in circulation is an important factor of creation of credit. If the primary deposits are large, then the derivative deposits created on their basis will also be large. But the volume of primary deposits is closely connected with the actual volume of currency in circulation.
If the volume of currency in circulation increases the volume of primary deposits will increase enabling the Commercial banks to create a large volume of derivative deposits. On the other-hand if the volume of currency in circulation decreases, the volume of primary deposits with the bank will also decrease leading to a decrease in the volume of derivative deposits created by the banks.
Limitation # 6. If heavy with-drawl of Cash by the Borrowers:
If the borrowers will withdraw money in cash, then the balance of deposits will be disturbed. With the withdrawal of cash, the excess reserves of the banks are automatically reduced. This reduces the power of credit creation.
Limitation # 7. Existence of Cash Transactions in the Economy:
This system of doing transaction sets another limitation on the power of the banks to create credit. In under-developed area most of the transactions have to be effected in cash. This puts a question as to what extent banks power to create credit is reduced.
But as the economy develops, the ratio of currency to total money supply decreases and that of bank money increases. This increases correspondingly the banks power of credit creation in the economy.
Limitation # 8. Economic Conditions of Trade and Business:
Banks cannot continue to create credit limitlessly. Their power to create credit depends upon the economic climate present in the country. If there are boom times, there is a greater scope of profitable investment and thus greater demand for bank loans on the part of businessmen.
The banks will, therefore, be able to create a greater volume of credit at such a time. Similarly, during the period of depression the scope of profitable investment is limited. Hence, the investors will be less inclined to borrow from the banks. Therefore, the banks power to create credit will be automatically reduced.
Limitation # 9. If Good Collateral Securities are not Available:
We are aware that every loan made by the bank must be backed by some valuable security like stocks, shares, bills and bonds etc. If these collateral securities are not available in sufficient number the banks cannot expand their lending activities and consequently cannot expand credit in the economy.
Limitation # 10. It is Essential to Maintain Statutory Liquidity Ratio:
The Commercial Banks under law are required to maintain a second line of defence in the form of the liquid assets. In India it has become essential to keep 34% of the assets in liquid forms. The liquid assets have been considered as government bonds and securities, treasury bills and other approved securities which can be en-cashed quite easily in emergency.
Such restrictions reduce the lendable resources with the banks and curtail their power to create credit to that extent.
Limitation # 11. If the Behaviour of Other Banks is Not Co-operative:
If some of the banks do not advance loans to the extent required of the banking system, the chain of credit expansion will be broken. The effect will be that the banking system will not operate properly.