Limitations on the Power of Banks to Create Credit

The following points highlight the ten major limitations on the power of banks to create credit. The limitations are: 1. Amount of Cash 2. Proper Securities 3. Banking Habits of the People 4. Minimum Legal Reserve Ratio 5. Excess Reserves 6. Leakages 7. Cheque Clearances 8. Behaviour of Other Banks 9. Economic Climate10. Credit Control Policy of the Central Bank.

Limitation # 1. Amount of Cash:

The credit creation power of banks depends upon the amount of cash they possess. The larger the cash, the larger the amount of credit that can be created by banks. The amount of cash that a bank has in its vaults cannot be determined by it. It depends upon the primary deposits with the bank. The bank’s power of creating credit is thus limited by the cash it possesses.

Limitation # 2. Proper Securities:

An important factor that limits the power of a bank to create credit is the availability of adequate securities. A bank advances loans to its customers on the basis of a security, or a bill, or a share, or a stock or a building, or some other type of asset.

It turns ill-liquid form of wealth into liquid wealth and thus creates credit. If proper securities are not available with the public, a bank cannot create credit. As pointed out by Crowther, “Thus the bank does not create money out of thin air, it transmutes other forms of wealth into money.”

Limitation # 3. Banking Habits of the People:

The banking habits of the people also govern the power of credit creation on the part of banks. If people are not in the habit of using cheques, the grant of loans will lead to the withdrawal of cash from the credit creation stream of the banking system. This reduces the power of banks to create credit to the desired level.

Limitation # 4. Minimum Legal Reserve Ratio:

The minimum legal reserve ratio of cash to deposits fixed by the central bank is an important factor which determines the power of banks of create credit. The higher this ratio (RRr), the lower the power of banks to create credit; and the lower the ratio, the higher the power of banks to create credit.

Limitation # 5. Excess Reserves:

The process of credit creation is based on the assumption that banks stick to the required reserve ratio fixed by the central bank. If banks keep more cash in reserves than the legal reserve requirements, their power to create credit is limited to that extent.

If Bank A of our example keeps 25 per cent of Rs. 1000 instead of 20 per cent, it will lend Rs. 750 instead of Rs. 800. Consequently, the amount of credit creation will be reduced even if the other banks in the system stick to the legal reserve ratio of 20 per cent.

Limitation # 6. Leakages:

If there are leakages in the credit creation stream of the banking system, credit expansion will not reach the required level, given the legal reserve ratio. It is possible that some persons who receive cheques do not deposit them in their bank accounts, but withdraw the money in cash for spending or for hoarding at home. The extent to which the amount of cash is withdrawn from the chain of credit expansion, the power of the banking system to create credit is limited.

Limitation # 7. Cheque Clearances:

The process of credit expansion is based on the assumption that cheques drawn by commercial banks are cleared immediately and reserves of commercial banks expand and contract uniformly by cheque transactions.

But it is not possible for banks to receive and draw cheques of exactly equal amount. Often some banks have their reserves increased and others reduced through cheque clearances. This expands and contracts credit creation on the part of banks. Accordingly, the credit creation stream is disturbed.

Limitation # 8. Behaviour of Other Banks:

The power of credit creation is further limited by the behaviour of other banks. If some of the banks do not advance loans to the extent required of the banking system, the chain of credit expansion will be broken. Consequently, the banking system will not be “loaned up”.

Limitation # 9. Economic Climate:

Banks cannot continue to create credit limitlessly. Their power to create credit depends upon the economic climate in the country. If there are boom times, there is optimism. Investment opportunities increase and businessmen take more loans from banks. So credit expands.

But in depressed times when the business activity is at a low level, banks cannot force the business community to take loans from them. Thus the economic climate in a country determines the power of banks to create credit.

Limitation # 10. Credit Control Policy of the Central Bank:

The power of commercial banks to create credit is also limited by the credit control policy of the central bank. The central bank influences the amount of cash reserve with banks by open market operations, discount rate policy and varying margin requirements.

Accordingly, it affects the credit expansion or contraction by commercial banks. We may conclude that commercial banks do not possess unlimited powers to create credit.