The basic function of every bank is to collect funds from excess owners of cash and lend to the borrowers who have cash shortage in their business; this is known as credit creation.
In essence, banks act as financial intermediaries. Credit creation by commercial banks comes in place when the excess owners forego the use of their money in anticipation of interest the bank must pay on the saved amount for the period and on the agreed interest rate.The bank has a responsibility and an obligation to it’s customers; the bank credit creation process entails that banks have to come up with strategies that will enable them meet the needs of the borrower and the excess owners.
The bank needs to lend the available fund to the borrower at a suitable interest rate so as to get the income to meet with it’s obligation to the savings customer and still keep the business running.
Thus credit creation is regarded as an important function of a commercial bank, this is the reason why money created and supplied by banks are referred to as credit money.
A successful bank is a financial institution that guides against risk within a given parameter, financial resources and credit competence.
For meaningful economic development and transformation to take place in any nation’s economy, there has to be an available financial capital as a pre requisite tool. Since the provision and efficient management of this scarce resources is best facilitated by the existence, dynamism and appropriate operating milieu.
It follows therefore that banks have a vital role to play by making their fast financial resources available for financing and promoting development.
In credit creation by commercial banks, the commercial banks carry out the responsibility of creating credit when they advance loans as well as other purchasing securities to their customers. As financial institutions, banks create money when they lend to individuals as well as businesses from the deposited funds by the public.
Bank Credit Creation has a direct effect on economic growth and business development of a nation and government in it’s mercy has usually integrated it into policy formulation and national economic development processes.
It therefore, suffices to say that credit policy guides lending officers in balancing the quality of the loan portfolio of the bank to achieve earning objectives while also meeting appropriate credit needs, maintaining proper credit standard, holding risk to reasonable limit, minimizing losses, evaluating new business opportunities, adjusting to change with regulatory environment and providing adequate liquidity.
However, in Credit creation by commercial banks, any financial institution can only succeed if it comply with the above mentioned critical factor in credit creation formula.
Credit Creation By Commercial Banks And Processes
There are various way of creating bank credit, banks create various types of credit depending on the source of repayment. Credit could either be classified as short term or long term credit.
1. Short Term Credit – Short term credit have maturity date of less than 12 months. As the name implies, it is for short term purposes and it is repaid through cash inflows of the company’s business. The source of repayment in various types of loans lies in the abilities to convert the current assets into cash. Their timely reconversions into cash should retire the bank debt and provide an increment to retained earnings to offset any inflationary cost increased and finance any growth.
Asset conversion loans are normally less risky than other loans due to the following reasons;
- They are only for a short term duration
- Future uncertainty is reduced
- Cash flow can provide a guaranteed source of repayment over a long time
2. Long Term Credit – This is a kind of credit that last over a one year period. Long term loans are repaid through the cash flow that are generated through many operating cycles. Almost all loans that is not repaid through the seasonal sales must be cash flow loans
Limitations Of Bank Credit Creation Process
Here are a few limitations of credit creation by commercial banks;
- The Lack of Securities: As a financial intermediary, banks must ascertain that the borrower has the proper security before a loan is advanced to him, failure to do this may result into loss of fund (Non performing loans).
- Business Environment: The business environment plays an important role, this is to say that the situation of things in a country will determine the level of loans advancement. Banks only advance loans when there are sound investment opportunities. In an economy where there is recessions and depressions, banks will most likely not advance loans.
- Lack of Cash: Lack of cash is considered when there the total amount of cash in the banking system limited, this will out rightly limit the volume of credit to be created. For this reason, banks have a reserve requirement which is certain percentage of cash reserved for this purpose.
- The Peoples Habits: The way people hold cash has an effect on Bank credit creation process. The thing is, when there is an increase in liquidity preference, then there is a high tendency that there will be less cash in the banks, this will in turn make banks to lend less. This occurs when people hoard cash and in most cases this happens in developing banking system. Hoarding of cash cuts down on power of banks in creation of credit.
Importance Of Credit Creation By Commercial Banks
The importance of bank credit creation cannot be over emphasised, as the creation of credit by banks is considered to be the most important functions of deposit money banks. The fact is that any financial institution has one singular aim, and that is earning profits.
In credit creation, banks ensure that the deficit unit of the economy are not choked due to lack of fund, as such an avenue is created for both the surplus and the deficit unit as well as the bank to make profit irrespective of each parties contributions. Banks accept cash in form of demand deposits from the general public (Surplus Unit) and then gives out loans on credit to customers (Deficit unit) for a cost. At the end of the day, the depositor’s cash is not left idle, the borrower gets money for his business and money is circulated.
The Assumptions Of Credit Creation By Commercial Banks
The bank credit creation process is built on the assumptions that;
- In the banking system, several other banks exist, like in the American banking system we have, Bank of America, Comerica, Synchrony Bank, Comenity Bank, Wells Fargo Bank, etc
- Another assumption is that every of the banks mentioned above has a percentage kept in its deposits reserves. This is known as reserve requirement which is ratio fixed by law.
- Another important assumption is that any amount taken as loan is deposited in full in another bank, meaning that when the loan is advance, the fund is moved to another bank, from that bank to another bank again and again.
- Another one is that every bank starts with an initial deposit as deposited by the other banks debtor
In conclusion, it is the duty of a commercial bank to create credit for its customers as that remains one of the most important function of a commercial bank.