Limitations of Credit Creation
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Limitations of Credit Creation

Limitations of Credit Creation Banks advance loans or buy securities without actually paying any cash. This is very tempting. They would, of course, like to make as much profit like this as they can.

Limitations of Credit Creation

Banks advance loans or buy securities without actually paying any cash. This is very tempting. They would, of course, like to make as much profit like this as they can. But they cannot go on expanding credit indefinitely. In their own interest, they will have to apply the brake .and they do actually apply it, for it is well-known that the profits made by the banks are not very high.

Benham has mentioned three limitations on the powers of the banks to create credit:—

(i) The total amount of cash in the country.

(ii) The amount of cash which the public wishes to hold.

(iii) The minimum percentage of cash to deposits which the banks consider safe.

As for (1), it may be said that credit can be created only on the basis of cash.

The larger the cash (i.e., the legal tender money), the larger the amount of credit that can be created. But the amount of cash that the bank may have is under the control of the Central Bank. The power of the Central Bank to control currency is the controlling influence on the extent of the credit that the banks have the power to create.

2. The second limitation arises from the habit of the people regarding the using of cash. If people are in the habit of using cash and not cheques as is the case in India, then as soon as credit is granted by the bank, the borrower will draw the cheque and get cash. When the bank's cash reserve is thus reduced, its power to create credit is correspondingly curtailed. On the other hand, if people use cash only for very small and odd transactions, then the cash reserve of the banks is not much drawn upon, and their power of creating credit remains unimpaired. This is the case in advanced countries like the U.S.A. and the U.K. and other European countries.

3. The third limitation is the most important. It arises from the traditional reserve ratio of cash which every bank considers its duty to maintain to ensure safety of the hanks and to retain the degree of liquidity that is desirable. It is obvious that when a bank creates credit, i.e., grants a loan and undertakes a liability, there is an increase in its liabilities and there is a corresponding fall in the reserve ratio. The bank will not let the ratio fall below a certain minimum. When that minimum is reached, the power of the bank to create credit comes to an end. To grant any further credit will be risky unless the bank's experience is reassuring enough to permit the adoption of a lower percentage. Then, that would be the limit.

4. To these may be added the fourth limitation. The bank cannot create credit without acquiring assets (in this case the borrower's promise to pay or some security). An asset is a form of wealth. Thus, the bank only turns immobile wealth into mobile wealth.

 

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