People keep their deposit in the bank. The bank gives interest on them. The bank has to earn in order to pay. The lend credit for all types of investment. Word credit is derived from the Latin word “credo”. It means “I believe”. The depositor believe that the bank shell pay him on demand. Hence the bank believes that he will not turn up to with draw his entire mount. It believes that the debtor shell pay of the debt in time with interest.
The deposits of the people are called primary deposits. What the bank keeps to meet the demand of the depositor is called “Cash Reserve”. So the excess of the primary deposits is called secondary deposits. Secondary deposits are the created credit. Every deposit creates credit and every credit creates deposits. Bank never lends cash. Therefore it always authorizes the borrower to draw upon it with cheques.
All type of transaction is under take with cheques and drafts etc. Every person getting the loan does the business with another person. The business man gets the payment in cheques. He deposits the cheques with the bank. Hence it gets the power to create the more credit on this basis. The size of the credit depends upon the Cash Reserve Ratio. Higher cash reserve ratio creates lesser credits while lower ratio creates more credit. Any with drawl are decrees in the primary deposits will decrease the credit creating capacity. It is not as destruction of credits.
The credit creating capacity of the bank not unlimited. There are certain limitation it creation of credit. They are as follow:
Size of the Deposit
The size of the primary deposit determines. The capacity of the bank to creates the credit. Increase in the deposit increases the capacity of the bank. So decrease in it decreases the capacity.
Cash reserve ratio is a check on the capacity in the creation of credit by bank. So higher reserve ration lowers of credit. This ratio is mostly determined by the central bank of the country. Lower reserve ratio expands the creation of credit.
Demand for Loan
The bank may have big primary deposit. They are useless of there is no demand for them form the people. The demand for loan is always for investment. People demand loans when there is political, social and economic peace in the country. Any unrest will badly affects the demand for loan. It main the bank has not free hands to create on expands the money.
Bank always lend against collateral securities. So they are in form of move able and unmovable property. Their size remains the same in the short period. Hence the credit creating capacity of the bank limited to the size of the collateral securities.