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Economics 2

Credit creation

takriban dakika 13 kusoma

Mada za sehemu hiiFinancial InstitutionMada 3
  1. The concept of Financial Institutions
  2. Types of Financial Institution
  3. Credit creation

This is a process through which commercial banks use cheque to expand the volume of money lent.

NB: The expanded credit is only in the form of book entry.

Example:

Assuming the cash ratio or reserve ratio is 20% and initial deposit is 1000. When people get loan they deposit cheque in their account in the same bank. If there are four people who are able and willing to borrow money the credit creation process will be as follows.

PersonNew depositsReserve at 20%New loan
A1,000200800
B800160640
C640128512
D512102.40409.60

Total credit created = 4,000

The number of times the money increases is called the credit multiplier.

Limitations of credit creation

  1. Leakage of money out of the banking system When people hold cash instead of depositing it into banks, the bank has fewer reserves to lend out, thus reducing the capacity to create credit.
  2. Liquidity ratio or reserve ratio – if ratio is low, credit creation is high The liquidity or reserve ratio is the fraction of customer deposits that banks are required to hold. A higher reserve ratio means less money available for lending, limiting credit creation.
  3. Illiteracy and attitude where some people do not keep money in banks Due to lack of financial knowledge or mistrust, many people in rural or underdeveloped areas avoid banks, leading to fewer deposits and reduced lending capacity.
  4. Regulation by the central bank which reduces the amount lent Central banks may impose restrictions like increasing the reserve ratio or interest rates to control inflation, which directly limits how much banks can lend.
  5. High interest rates which discourage borrowing When borrowing costs are too high, fewer individuals or businesses are willing to take loans, reducing overall credit creation.
  6. Very low interest rates which discourage saving If interest rates on savings are too low, people may prefer to keep their money elsewhere, reducing the deposit base banks use to extend credit.
  7. Lack of creditworthiness among customers Many potential borrowers may not meet the banks' requirements for loans, either due to poor credit history or unstable income, limiting how much credit can be safely extended.

Problems facing commercial banks

  1. Shortage of funds for loans to customers When deposits are low or capital is insufficient, banks struggle to meet the loan demand of customers.
  2. Illiterate customers A large number of customers may lack financial literacy, leading to poor use of banking services and high default risk.
  3. Insecurity of commercial banks due to frequent robbery attempts In areas with weak law enforcement, banks face physical security risks, which can raise operational costs or discourage investment.
  4. Most banks are undercapitalized, hence the level of operation is restricted Limited capital restricts a bank's ability to expand its services, make investments, or withstand financial shocks.
  5. Inflation discourages lending High inflation reduces the real value of repayments, increasing the risk to banks and discouraging them from lending.
  6. Most banks are located in towns facing steep competition Urban concentration leads to overcrowding of banks in cities, making competition intense and profitability lower.
  7. Collapse of banks resulting from failure of shareholders to repay loans When shareholders or large clients default on loans, it can lead to insolvency, causing the entire bank to collapse.

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