Introduction:

Commercial banks are financial institutions that offer services to individuals, businesses, and other organizations. They are primarily engaged in accepting deposits from customers and providing loans and credit facilities, among other financial services. Credit creation of commercial banks is the main cooperation with the central bank of any nation.

These banks play a very role in the economy by facilitating the flow of money and credit, which supports economic growth and development.

Credit creation by commercial banks refers to the process through which banks create new money by extending credit to borrowers. This process is facilitated through the reserve banking system, where banks are required to hold only a part of their deposits as reserves, allowing them to lend out the remaining.

Credit Creation of Commercial Banks:

1. Deposits: When customers deposit money into their bank accounts, banks hold a part of these deposits as reserves (required by central banks) and lend out the rest.
2. Reserve Requirement: Central banks set a reserve requirement, which is the minimum percentage of deposits that banks must hold as reserves. For example, if the reserve requirement is 10%, a bank with $1 million in deposits must hold $100,000 as reserves and can lend out the remaining $900,000.
3. Lending: Banks extend credit to borrowers by providing loans and mortgages. When a loan is issued, the borrower’s account is credited with the loan amount, effectively creating new money in the form of a deposit.
4. Money Creation: This process effectively increases the money supply in the economy. While the original depositor still has access to their funds (since banks only need to hold a fraction in reserve), the borrower now also has access to the funds they borrowed, effectively increasing the total money supply in the economy.
5. Re-deposit: When the borrower spends the loaned amount, it typically ends up being deposited into another bank account. This process can repeat itself multiple times, further multiplying the initial deposit through subsequent rounds of lending and spending.
6. Reserve Adjustment: As banks continue to lend and create new money, they may need to adjust their reserves to meet the reserve requirement. They can do this by borrowing from other banks or borrowing from the central bank.
7. Interest: Banks charge interest on the loans they provide, which serves as their primary source of profit.

CONCLUSION:

It’s important to note that while commercial banks have the ability to create credit, this process is regulated by central banks through monetary policy tools such as reserve requirements, interest rates, and open market operations to control the money supply and ensure financial stability. It is the RBI who controls the flow of money with its instrument called Monetary policy by adopting qualitative and quantitative methods.

also read: explain the functions of commercial banks.