Credit Creation

Topics: Fractional-reserve banking, Bank, Central bank Pages: 6 (1793 words) Published: January 22, 2013
With introduction and use of money, credit also came into existence. Credit is created when one party (it can be person, group of people, firm or an institution) lends money to another party, the borrowers. The act of borrowing creates both credit and debit. Debt means the obligation to pay the finance borrowed and credit means the claim to receive this money payment from the other party. Every credit involves debt, that is obligation to pay money and therefore creates claim. 1.1 Definition of important terms

1.1.1 Credit is generally understood to mean the finance provided to others at certain rate of interest (Mudida 2003).The act of borrowing and lending and there by the creation of credit is a special type of exchange transaction which involves future payments of the principle sum borrowed as well as rate of interest on it. The lending and borrowing of money and institution of money lending came into practice since money was invited by man (ibid).

1.1.2 Commercial Bank is a business organization which deals in money, it borrow and lend money in with purpose of generating profit Ahuja 2008).

1.1.3 Central Bank, Reserve Bank or Monetary Authority is a public institution that manages a state's currency, money supply, and interest rates. Central banks also usually oversee the commercial banking system of their respective countries. In contrast to a commercial bank, a central bank possesses a monopoly on increasing the nation's monetary base, and usually also prints the national currency, which usually serves as the nation's legal tender ( 2.0HOW BANKS CREATE CREDITS

The source of money supply in the form of currency is circulation in Central Bank. It ensures the availability of currency to meet the transaction needs of the economy. The total volume of money in the economy should be adequate to facilitate the various types of economic activities such as production, distribution and consumption.

The commercial banks are the second most important source of money supply. The money that commercial banks supply is called credit money. The process of credit creation begins with banks lending money out of primary deposits. Primary deposits are those deposits which are deposited in banks. Bank cannot lend entire primary deposits as they are required to maintain a certain proportion of primary deposits in the form of reserve with the Central bank and Banking regulation act. After maintaining the required reserves, the bank can lend the remaining portion of primary deposit and here the process of credit creation starts.

Suppose there are a number of commercial Banks in the banking system – Bank 1 is required to maintain a cash reserve at let say 10% (which is decided by BoT). Bank one has to keep 1000 which is 10% of TZS10000. The remaining TZS9000 can be lent to another customer let say b, where bank 1 will open an account in the name of borrower cheque for the loan amount. At the end of deposits and lending, the balance sheet of bank 1 will be as follows:- Liabilities| Amount| Assets| Amount|

A’s deposits| 10000| Cash reserve| 1000|
| | Loan to ‘B’| 9000|
Total| 10000| | 10000|

Now, suppose that money that borrowed from Bank 1 is paid to individual C in settleling his past debts. Individual ‘C’ deposits the money in his bank say, bank 2. Now bank 2 carries out its banking transaction. It keeps a cash reserve to the extent of 10% that is TZS900 (10% 9000) and lend TZS8100 to borrower D at the end of process the balance sheet of bank 2 will look like:- Liabilities| Amount| Assets| Amount|

C’s deposits| 9000| Cash reserve| 900|
| | Loan to ‘D’| 8100|
Total| 9000| | 9000|

The amount advanced to D will return ultimately to the banking system as described in case of B and process of deposits and credit creation will continue until the reserve with banks is reduced to zero. The final picture that would emerge at the end of the...
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