Money & Banking Credit creation by Rabia Qayyum

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Information about Money & Banking Credit creation by Rabia Qayyum

Published on April 27, 2014

Author: rabiaqayyum520


In simple words credit creation means the multiple loaning by commercial banks. A single bank cant create credit. But banks in multi banking system can grant several loans out of a single deposit.

LIMITATIONS OF CREDIT CREATION: The credit creation process just discussed is very simplified one. Infect there are many restrictions and constraints over this. This process is guided and affected by variety of factors like:  Currency Drains  Excess Reserves  Primary Depositor  Cash Reserve Ratio  Economic circumstances  Monetary Policy  Different Types of Deposit

1.CURRENCY DRAINS: An assumption of our credit creation process is that all receipts and payments are made by cheques. In reality this may not go like this. A borrower may wish to take cash instead of cheques.

In our simplified model we have said that banks hold only 20 percent reserves and rest of the amount is lent out. However in reality no commercial bank works like that. 2 . EXCESS RESERVES:

3. PRIMARY DEPOSIT: The credit creation process depends on the availability of primary deposit. If banks have adequate primary deposit only then they can create credit. There is a direct relation between primary deposit and credit creation.

4. CASH RESERVE RATIO: Another constraint on the lending potential of the commercial banks is the reserve ratio. Our banks are required to hold some percentage of their demand deposits as reserve with the central Bank.

5. ECONOMIC CIRCUMSTANCES: Commercial banks can’t create credit on their own or according to their own will and wish. They can only make it when borrowers demand loans. The economic circumstances and monetary situation effect the credit creation.

6. MONETARY POLICY: The extra ordinary or unnecessary credit expansion may prove harmful for the economy in all countries central banks are vested with power to influence lending powers of commercial banks.

7. DIFFERENT TYPES OF DEPOSITS: Commercial banks accept three main different Types of deposits which are:  Demand Deposits  Saving Deposit  Fixed Deposit DEMAND DEPOSITS: All deposit received by banks are demand deposit. Funds held in an account from which deposited funds can be withdrawn at any time without any advance notice to the Depository institution. Demand deposits can be "demanded" by an account holder at any time.

SAVING DEPOSIT: A deposit account held at a bank or other financial institution that provides principal security and a modest interest rate. Depending on the specific type of savings account, the account holder may not be able to write checks from the account (without incurring extra fees or expenses) and the account is likely to have a limited number of free transfers/transactions. FIXED DEPOSIT: Fixed Deposit refers to a savings account or certificate of deposit that pays a fixed rate of interest until a given maturity date. Funds placed in a Fixed Deposit usually cannot be withdrawn prior to maturity or they can perhaps only be withdrawn with advanced notice and/or by having a penalty assessed.

CREDIT ANALYSIS: According to some bankers “credit” is an evolution of Latin word “creditium” which means “trust”. Basically it is element of trust that runs the whole mechanism of credit. The first relation between lender and borrower is that of trust.

TRADITIONAL FACTORS: There are certain policy guidance and factors which have been followed since long by the bankers while making a lending decision. These factors are:  Credit worthiness of the borrower  Record of Bank Dealings  Size of Business

CREDIT WORTHINESS OF THE BORROWER: This was dependent on the information that lending officer “possessed” about the borrower. RECORD OF BANK DEALINGS: SIZE OF BUSINESS: The borrower record of bank dealing was next to examine. A normal record of dealing with bank was considered positive sign to grant credit. If the size of business was found comparable with the amount of loan applied, the lending officer gave approval of credit.

DIFFERENTIATING RETAIL AND CORPORATE CREDIT: RETAIL CREDIT: Retail credit is the usual business credit. Such Credit requirements are not extraordinary huge and the business structure is also simple. CORPORATE CREDIT: Corporate credit deals with corporate business houses, industries, concern etc. Banks have differentiated modern retail and corporate credit.

3CS WHICH ARE NORMALLY FOLLOWED FOR GRANTING CREDIT ARE: CHARACTER: The character is established by the information like conduct the borrower, background, means of earnings, mode of living etc. CAPACITY: Capacity means the ability to repay the loan. CAPITAL: Capital means the assets owned by the borrower. If the borrower is sound in respect of the assets and properties held by them, then the lending officer approves the credit.

OTHER MODERN & IMPORTED FACTORS ARE: Financial statement analysis: Financial statement have gained importance in modern world. There are three financial statement. 1) Profit and loss account 2) Balance sheet 3) Cash flow statement

 PROFIT AND LOSS ACCOUNT: It is a summary of revenues earned and expenditures incurred by an enterprises in a given year.  BALANCE SHEET: It is a snapshot of the financial position of the business at a particular date.  CASH FLOW STATEMENT: These statements disclose the liquid cash available and the net increase and decrease in cash equivalents during a year.

RATIO ANALYSIS: Ratios are various types. They may be financial, managerial, commercial, or operational. What all the ratios do is that they may help in the understanding of a complex, diversified and vast data in an easy way. They express complex information in an understandable manner. Ratio analysis are also important while making a lending decision.

PROFIT PROJECTION ANALYSIS: Such analysis help in determining the future trend of business and anticipated revenues. SOURCES & APPLICATION OF FUNDS: This involves the visualising of funds received by the business from sources and the applications and utilisation of these funds. Such analysis helps the lending officer to determines the credit worthiness of the borrower.

EXCHANGE TRANSLATION ANALYSIS: Where the loans are to be given to the business which is being operated from abroad or which is export oriented, exchange translation analysis is made. INFLATION ACCOUNTING: A statement is prepared that shows the real worth of the business according to the prevailing general price level.

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