Introduction

Commercial banks play an essential role in the economy

through the process of credit creation. This function of
commercial banks is crucial for maintaining a steady flow of
money in the economy. The central bank of a country
manages the supply of money in the economy by circulating
currency. However, it cannot execute this task alone and
relies on commercial banks and their reserves. Commercial
banks thus contribute to the economy by creating credit.

The money created by commercial banks, known as credit

money, is generated through the purchase of securities and
provision of loans. These loans are facilitated using the
deposits received from the public.

However, commercial banks cannot freely lend all the

deposits they receive. A certain portion of these deposits
must be maintained as reserves with the central bank, which
can be used to meet immediate cash requirements of
depositors.
History of Commercial Banks in India

There are Commercial Banks in India that have existed for more than a century. They are
expanding into the provinces and have locations all over the country. Since India's
independence, commercial banks have gone through three phases. Between 1955 and 1970,
a public-sector appeared within Indian banking. It began with the establishment of the
National Bank of India in 1955 and culminated in the nationalization of fourteen significant
banks in 1969. In the 1970s and 1980s, mass banking began to replace class banking twenty
years after banks were nationalized. There was a significant increase in branch growth during
this time, which was followed by the hiring of a large number of bank employees and
increased funding for priority sectors, particularly those that were underserved and had
lower incomes.

Commercial Banks provide the general public, including individuals and small businesses,
with basic banking services. In the period following nationalization, there were challenges.
The issue of loan non-collection has gotten worse as a result of inadequate training, as have
financing expectations to meet regulatory standards, resulting in a decline in bank
profitability. This was the situation in 1991, when the government unveiled a new economic
strategy. Sri M. Narasimha headed a committee on the financial sector to make a number of
suggestions for banking institutions to improve their efficiency, output, and profitability.
Banks make money by determining fees and charges for services. Depending on the items
provided, fees such as overdraft fees, locker fees, and reminder fees change. Various loans
include a variety of costs in addition to the loan's interest. Consumer deposits provide funds
for banks, and lending generates profits. They offer their customers relatively low interest
rates on deposits, but they charge higher interest rates on loans. A bank might, for instance,
offer savings accounts interest rates of 2% while charging mortgages annual interest rates of
4.8 percent. Customers can easily access the services offered by Commercial Banks when
they are located close to ATMs and other teller facilities. The majority of banks now allow
their customers to conduct the majority of their transactions online as a result of recent
advancements in internet technology. People can now send money, deposit money, and pay
their bills online.

Commercial Banks are essential to the economy because they provide essential services to
their customers, increase market liquidity, and generate capital. By lending against
customers' deposits, banks keep the market liquid. By assisting in the creation of the credit
that boosts output, employment, and consumer spending, commercial banks contribute to
economic expansion. As a result, the central bank of their nation or region imposes stringent
regulations on commercial banks. Commercial banks, for instance, must meet the central
bank's reserve requirements. As a result, in the event that customers request cash
withdrawals, banks are required to reserve a certain percentage of client deposits at the
central bank as a safety net.
Meaning of Credit Creation: -

Credit creation is the process by which the money supply of a

country or of an economic or monetary region is increased. In
most modern economies, most of the money supply is in the
form of bank deposits. 50 credit creation is also known as
'Deposit Creation'. It is a situation in which banks make more
loans to customers and business, with the result that the
amount of money in circulation (being passed from one person
to another) increases.

In simple terms, credit creation is the expansion of deposits.

Banks can expand their demand deposits as a multiple of their
cash reserves because demand deposits serve as the principal
medium of exchange.

Commercial Banks create credit by advancing loans and

purchasing securities. They lend money. to individuals and
businesses out of deposits accepted from the public. However,
commercial banks cannot use the entire amount of public
deposits for lending purposes. It is legally compulsory for the
banks to keep a certain minimum fraction of their deposits as
reserves. The fraction is called the Legal Reserve Ratio (LRR)
and is fixed by the Central Bank. After keeping the required
amount of reserves, Commercial banks can lend the remaining
portion of public deposits

Formula for determining the Credit creation

The following formula can be used to determine the total credit creation.
Total credit creation = Original deposit ✕ Credit multiplier coefficient
Where,
Credit multiplier coefficient = 1/r
r = Cash reserve requirement also known as cash reserve ratio (CRR)
Let us understand this with an example.
If the money deposited in a bank is ₹10,000 and the bank has a CRR of
10%, then what will be the credit multiplier coefficient?
Credit multiplier coefficient = 1/10%
= 1/0.1
= 10
Total credit creation = 10,000 ✕ 10 = 1,00,000
Similarly, if CRR = 20%
Then,
Credit multiplier coefficient = 1/20%
= 1/0.2
=5
Therefore, total credit creation = 10,000 ✕ 5 = 50,000
From the given values we can understand that, a low CRR value results in
high credit creation and a high CRR results in low credit creation.
Therefore, with the help of credit creation, the money gets multiplied in
the economy.
However, the commercial banks face many challenges and limitations
while performing the credit creation in an economy are further discussed.

Functions of Commercial Bank

Commercial Banks perform various functions which can be categorised into two
broad categories; viz., Primary Functions and Secondary Functions.

A. Primary Functions
Accepting Deposits and Advancing of Loans are the two primary functions
performed by commercial banks.

1. Accepting Deposits
One of the most essential functions of commercial banks is accepting deposits.
Commercial banks accept deposits from their customers in different forms
based on the requirements of different sections of society. The main types of
deposits include:
Demand Deposits or Current Account Deposits: The deposits which are
repayable on demand by the banks are known as demand deposits or current
account deposits. In general, these kinds of deposits are maintained by
businessmen to make transactions with these deposits. One can get the
amount deposited as Demand deposits by a cheque without any restriction.
Besides, commercial banks do not pay any interest to the depositors on these
accounts; instead, they charge some amount as a service charge for running
these accounts.
Fixed Deposits or Time Deposits: The deposits in which the depositor, deposits
money with the bank for a fixed time period are known as fixed deposits or
time deposits. These deposits do not enjoy a cheque facility and carry a high
interest rate.
Saving Deposits: The deposits, which include combined features of demand
deposits and fixed deposits are known as saving deposits. The depositors have
the cheque facility to withdraw money from their accounts, but there are some
restrictions on the number and amount of withdrawals. The restrictions are
imposed to discourage the frequent use of saving deposits. Besides, the
interest rate on saving deposits is less than the interest rate on fixed deposits .

2. Advancing of Loans

The banks are not allowed to keep the amount deposited with them,
idle. Therefore, commercial banks have to keep some amount of the
total deposits as cash reserves and lend the rest of the balance to
needy borrowers and charge interest from them. The interest
received by commercial banks from advancing loans is the main
source of their income. Some of the different types of loans and
advances made by commercial banks are:
Cash Credit: The loan given to the borrowers against their current
assets like stocks, bonds, shares, etc., is known as cash credit. For
this, a credit limit is sanctioned to the borrower, and money is
credited to this account. The borrower can now withdraw any
amount at any time within his credit limit. Interest is charged from
the borrower on the amount actually withdrawn by him.
Demand Loans: The loans given by the banks which they can recall at
any time on demand are known as demand loans. The entire amount
of the demand loan is credited to the borrower’s account, and
interest is charged on that amount.
Short-term Loans: Personal loans given to borrowers against some
collateral securities are known as short-term loans. The amount
taken as a loan is credited to the account of the borrower, and he can
withdraw that money from his account. Interest is charged on the
entire sum of the loan granted.

B. Secondary Functions
Besides primary functions, commercial banks also perform some secondary
functions.

1. Overdraft Facility
A facility that allows the customer to overdraw from the amount of his current
account upto an agreed limit is known as an overdraft facility. In general, an
overdraft facility is given to respectable and reliable customers for a short period.
Besides, the customers have to pay interest on the amount overdrawn by them.

2. Discounting Bills of Exchange

A facility in which the holder of a bill of exchange, before its maturity date can get
the bill discounted with the bank. The bank pays the amount to the holder after
deducting some amount as commission. Now, on the date of maturity, the party
which has accepted the bill pays back the money to the bank.

3. Agency Functions
There are some agency functions performed by commercial banks for which they
charge some commission from their clients. Some of these functions are:
 Transfer of Funds: With the help of instruments like mail transfers, demand
drafts, etc., commercial banks provide their customers with the facility of
easy and economical remittance of funds from one place to another.

 Collection and Payment of Various Items: Commercial banks provide their

customers with the service of collecting bills, interest, subscriptions, rents,
and other periodical receipts on their behalf. They also make payments for
insurance premiums, taxes, etc., on their customer’s standing instructions.

 Purchase and Sale of Foreign Exchange: The central bank gives authority to
commercial banks to deal in foreign exchange. Commercial banks, on the
behalf of their customers, buy and sell foreign exchange and also helps in
promoting international trade.

 Purchase and Sale of the Securities: Commercial banks on behalf of their

customers, purchase and sell government securities and stocks and shares
of private companies.
  Income Tax Consultancy: Commercial banks provide advice to their
customers related to income tax. They also help them in the preparation of
their income tax returns.

 Trustee and Executor: Commercial banks play the role of a trustee and
preserve the will of their customers and as an executor, execute the will
after their death.

 Letters of Reference: Commercial banks provide information about the

economic position of their customers to the traders and vice-versa.

4. General Utility Functions

Some of the general utility functions performed by commercial banks are:
 Locker Facility: Commercial banks provide their customers with the facility
of lockers or safety vaults so they can keep their valuable things in safe
custody.
 Traveller’s Cheques: To avoid the risk of taking cash on their journey,
commercial banks provide their customers with the facility of traveller’s
cheques.
 Letter of Credit: Sometimes people need to show their creditworthiness for
various reasons. Commercial banks certify the creditworthiness of their
customers whenever required.
 Underwriting Securities: Commercial banks also perform the function of
underwriting securities. And as the public has full faith in the bank’s
creditworthiness, they do not hesitate in purchasing the securities which
are underwritten by banks.
 Collection of Statistics: Commercial banks advice their customers on
financial matters by collecting and publishing statistics related to
commerce, trade, and industry.

Limitations of Credit Creation

The following are some of the limitations that are experienced by the commercial
banks during the credit creation process.
 1. Cash amount present in the bank
The higher the amount of deposits made by the public, the higher credit creation
from the commercial banks can be seen. However, there is a certain limit on the
amount of cash that can be held by the banks at a time.
This limit is determined by the central bank, as the central bank may contract or
expand this limit by selling or purchasing the securities.
2. Cash reserve ratio or CRR
It refers to the amount of money in the form of reserve that needs to be kept
with the central banks by the commercial banks. This amount is used for meeting
the cash requirements of the users. Any fall in the CRR will lead to more credit
creation.
3. Excess reserve
This takes place when a country faces recession, at that time the banks find it
conducive in maintaining reserves in place of lending that leads to less credit
creation.
4. Currency drainage
It refers to the situation when the public is not depositing money in the banks.
This results in reduced credit creation in the economy.
5. Borrower availability
Credit creation will flourish if there are borrowers. The credit creation will not be
done if there are no borrowers of the money in an economy.
6. Prevalent business conditions
If an economy is witnessing a depression, then the businesses will not be seeking
credit that leads to contraction of credit creation. Whereas, if a nation is
prospering, then the businesses will seek new funds in the form of credit from
the banks that would lead to credit creation.

The two most important aspects of credit creation

are:

1) Liquidity: The bank must pay cash to its depositors when they exercise
their right to demand cash against their deposits.
2) Profitability: Banks are profit driven enterprises. Therefore, a bank must
grant loans in a manner which earns higher interest than what it pays on
its deposits,

The bank's credit creation process is based on the assumption that during
any time internally, only a fraction of its customers genuinely need cash.
Also, the bank assumes that all its customers would not turn up
demanding cash against their deposits at one point in time. The bank is
thus enabled to erect a vast superstructure of credit on the basis of a
small cash reserve. The bank is able to lend money and charge interest
without parting with cash. The bank loan creates a deposit, or it creates a
credit for the borrower.

Similarly, the bank buys securities and pays the seller with its own cheque
which again is no cash, it is just a promise to pay cash. The cheque is
deposited in some bank and a deposit is created or credit is created. This
is credit creation.

Conclusion of Credit Creation by

Commercial Bank

Commercial banks play a central role in the process of credit

creation, which is essential to the functioning of modern
economies. By leveraging the fractional reserve banking
system, banks are able to create credit by lending out a portion
of the deposits they receive, while keeping only a fraction in
reserve. This credit creation expands the money supply,
stimulates economic activity, and enables businesses and
individuals to access funds for investment, consumption, and
economic growth.
However, credit creation also has its risks. Excessive lending
can lead to inflation or the creation of asset bubbles, while
inadequate credit creation during economic downturns can
exacerbate recessions. Thus, the role of regulatory authorities,
such as central banks, is crucial in managing and overseeing
the lending practices of commercial banks to ensure financial
stability.

In summary, while credit creation by commercial banks is a

vital driver of economic growth, it needs to be carefully
managed to balance growth with financial stability, preventing
both inflationary pressures and the risk of a financial crisis .