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Summary CONCEPT OF CREDIT AND THE CREDIT CREATION PROCESS BY COMMERCIAL BANKS
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- Oxford University (OX)
CONCEPT OF CREDIT AND THE CREDIT CREATION PROCESS BY COMMERCIAL BANKS
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LESSON IICONCEPT OF CREDIT AND THE CREDIT CREATION PROCESS BY
COMMERCIAL BANKS
Meaning and Features of Credit
In general terms, credit, a word that took its origin from Latin meaning “to believe or trust” has
been adopted as an economic term. As an economic term, credit usually refers to “a promise by
one party to pay another for money borrowed or goods or services received. It is also a medium
of exchange to receive money or goods on demand at some future date. “It can however be
referred to, as many economists do, “as the right to receive payments or the obligation to make
payment on demand at some future time on account of the immediate transfer of goods.”
For credit to successfully satisfy its object, the following essential features must be present:
Trust and confidence on the part of the borrower or buyer to the lender or seller.
Time element, when the money or goods will be paid back or returned.
Transfer of goods and services between the seller and buyer.
The willingness and ability of the parties concerned, this is hinged on character (honesty),
capacity and capital of the parties in the transaction.
The purpose of the credit presupposes the credit transaction either production or
consumption purpose.
Security or collateral which is, in most cases, the base or important element for raising
the credit.
CREATION OF CREDIT
Creation of credit means that process under which commercial banks advance loans many times greater
as compared to legal money at the disposal of commercial bank. Thus, credit creation requires bank
opening a deposit every time they make loan available to customers. The customers in turn open
account through which payments and withdrawals are made Thus bank loan creates deposits and
it is in this sense that credit is credited by commercial banks. Banks do not give out all deposit
they receive on loans and also depositors do not withdraw their money simultaneously. They
therefore keep small cash in reserve for day-to-day transactions, and then advance the excess on
this reserve on loans. Also, the banks are legally required to keep a fixed percentage of their
, deposits in cash, and lend or invest the remaining amount which is called excess reserves. The
entire banking system can lend and create credit upon a multiple of its original excess reserves. It
calculates the maximum amount of money that an initial deposit can be expanded to with a given
reserve ratio – such a factor is called a multiplier.
Example
If legal money available with commercial banks is 100 million and on the basis of this
amount loans of sh.1000 million are issued, it is known as “creation of credit” by creation of
credit. We do not mean printing of new notes; it is just excessive use of instrument of credit.
The process of creation of credit can be explained by the use of the following example;
We assume there are different banks in any country. If a loan of 100m is issued by bank
“A”, it will result into advanced loans many times greater than this amount as shown in the
following example.
Bank “A” Bank “B” Bank “C” Bank “D”
Excess reserve 100
Primary deposit 100 90 81
Reserve ratio 10%
In the above example, the loan of 100 was advanced by bank “A” and the person who
receives this loan will not spend this money in the short period, we assume this person
deposit this money to bank “B”. Now bank “B” knows from its experience that this
person will withdraw only 10% as reserve and will advance a loan of 90.00 to another
person for 1 year. In this way another loan of 90.00 will be advanced or the basis of the
same amount. This process will continue until the total amount, which was originally
advanced by bank “A”, will disappear in the form of reserves kept by difference banks. We
can use the following formulae to find one the creation of credit.
Creation of credit = Excess reserve
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