Do Banks Create Credit...?

1

An Assignment of Money, Banking & Finance by Ma’m Sundas Shahnwazz…!

Ali

Do Banks Create Credit…?Introduction

Money Creation is the process by which new money is produced or issued in the public market for their various use in whole of the economy. The central bank of this economy handles the affairs of money supply, according to needs of the economy. The total volume (amount) of money in the economy should be adequate to facilitate the various types of economic activities such as production, distribution and consumption.

Credit Creation is ability of banks to create credit I the economy as whole. In reality credit creation is the ability of banking sector to expand the money supply by making more loans in the economy in very efficient and effective manner.

In any economy, the central bank is the first source of money supply in the form of currency in circulation. And, the commercial banks are the second most important sources of money supply. In common words the money which circulates through central bank is known as “Money Creation”, and the money which circulates through commercial banks is called “Credit Creation”.

There are three ways to create money in the economy as:-

By Note Issuing

By Debt & Lending (Borrowing)

By Government Policies

We know that the practices and regulation of production, issue and redemption of money are of central concern to monetary economics, because all of them effect the operation of financial markets and the purchasing power at each & every level.

Submitted by Ali Raza Sahni

2


Ali

Credit Creation

According to M. Saeed Nasir in his book “Money, Banking & Finance”, the credit creation is defined in these words as:-

“The tendency of the banks to makes loans several times of the excess cash reserves kept by the banks is called creation of credit.”

The credit creation is most important function of commercial banks, like other of financial institute (banks) which having the aim just to earn profit by make advance to other. Therefore, some time these institutions are called Factory of Credit Creation.

Everyone commonly knows that the people cannot withdrawal their money in simultaneous manner, some of them with drawl, while other deposit it for some time period. So, the bank encourages credit creation by given advance to other and keep very small cash in their reserves for day to day transactions.

Process of Credit Creation

The process of credit creation begins with banks lending money out of primary deposits. Primary or Initial deposits are those deposits which are deposited in banks. In fact banks use this deposited money in various business to make the profit. The major or primary objective to make the profit is starts by lending the money on heavy interest basis and makes a huge profit in specific limited time period.

For this purpose banks cannot lend the entire amount of the initial deposits but also maintain a certain proportion as reserves form for day to day transactions. The ratio of reserves on initial deposits is allotted by the central bank of the economy. So, in this manner banks lend the money and create the process of credit creation in the economy.


3


Ali

General Example

Let us consider that, if a number of banks are present in the country. Mr. Ali maintained an account in the National Bank of Rs. 10000/- only. And the current reserve ratio by State Bank of Pakistan (SBP) is 10%.

Then National Bank wants to lend the money of Mr. Ali to make up the profit. For this purpose National Bank maintain the reserve of Rs. 1000/- (the 10% of initial deposit) and sanctioned the loan of Rs. 9000/- (10000-1000) to Mr. Hassan.

Then Mr. Hassan gets the loan from National Bank of amount Rs. 9000/- on agreed interest ratio. And deposit this whole amount in Habib Bank in his new account for their future needs. So Habib Bank maintains the account of Mr. Hassan with Rs. 9000/- only and for the purpose to earn profit it will sanctioned the loan to another one.

Lets if Habib Bank kept the reserve amount Rs. 900/- only (the 10% of 9000) and issued the loan of Rs. 8100/- only (9000-900) to Mr. Hasnian. And then Mr. Hasnian saves this amount in the account of Muslim Commercial Bank (MCB) for their future needs.

Then MCB will issued the loan of Rs. 7290/- only to another person by keeping the reserve amount of Rs. 810/- only for there daily to daily transactions. Lets this person is Miss. Sana. And, Miss. Sana saves their loaned amount in the accounts of Standard Charted Bank for their personal as well as others needs.

Then Standard Charted Bank issued the loaned to another person by keeping their reserves amount for their daily usages. And this process will continue…!


4


Ali

The statistical view of this example is here as-

Deposited By Amount Bank Reserved (10%) Loan Issued(Name) (Rs) (Name) (Rs) (Rs)

Ali 10000 National 1000 9000Hassan 9000 Habib 900 8100Hasnian 8100 MCB 810 7290

Sana 7290Standard Charted

729 6561

Haider 6561 Allied 657 5904Kiran 5904 My 591 5313Sara 5313 Askari 532 4781------- ------- -------- ------- ------

n Persons 100000/- n Banks 10000/- 90000/-

Specific Terms

Reserve Amount: The amount which is reserved for the daily banks transactions from the initial deposits of banks, allocated by the central bank of the economy. Its shows in percentage scale and represented by “r”.

Loaned Amount: The amount which is sanctioned as loan to any person who required this amount for their own need by deducting the reserved amount from the initial deposits.

Credit Multiplier: The co-efficient which is obtained by taking the reciprocal of reserve ratio allotted by the central bank on the primary deposits. Its shows the


5


Ali

number of times that an initial deposit can multiply in the process of credit. It’s denoted by “m”.

Change in Credit: The ultimate change in credit in the whole banking sector by this credit creation process, we get the ratio of change in credit in specific time period. It’s denoted by “D”.

General Equations of Credit Creation

There are following some conditional equations which are commonly utilize to get the formal analysis of credit creation in any economy as:-

Reserve Ratio = r Credit Multiplier (m) = 1 / r Change in Credit (D) = 1/ r x E E = Initial Deposit

Solution:

By keep in mind the above example, we know that the reserve ratio is 10% by the SBP and primary deposit is Rs. 10000/- only.

Then,

Reserved (r) = 10% = 10 / 100 = 0.1 = 1 / 10 Credit Multiplier (m) = 1 / 0.1 = 10 Change in Credit (D) = 1 / 10 x 10000 E = Initial Deposit -------------------------- = 1000 is the credit creator amount


6


Ali

Credit Contraction

The bank’s deposits create loans and the loans create deposits. Similarly the withdrawal of deposits contracts credit in the economy. In common the gradual reduction in money to sanction the loans by keeping the reserves creates the credit contraction.

The credit contraction phenomenon makes it harder for customers to obtain credit from the financial institutes. But on the other hand the credit contraction may also help to encourage the savings deposits in the standard savings accounts or in the form of certificates of deposit.

It is very important to note that credit contraction do not always yield immediate results. The contractions may remain in place for various months to a year before the desired effect takes place. In the interim, consumers often will cut back on impulse spending and focus on purchasing necessities rather than luxury items.

Limitations of Credit Creation

There are certain limitations by the monetary & banking system to creates the credit in the economy as:-


7


Ali

Cooperation of Commercial Banks: The process of credit creation is effective and possible only with the co-operation of commercial banks. If there is no co-operation among the banks, the process can not be completed because central bank only creates (issue) the money but commercial banks creates the credit of money by issuing the loans in the market.

Cash Liquefy (Drain): To create the credit in the economy it is compulsory that all of the payments are made by cheques and not in cash. Simply, bank transaction is valid to create the credit the cash transaction is not. In case, borrowers withdraw the loaned amount in cash, then banks will not be able to create credit. Its means an outflow of cash from the reserves of the banks will reduce their ability to expand deposits and vice versa.

Central Bank Policy: The commercial banks can create credit only under the policy of central bank just to maintain the stable form of economy. In case of inflation, the central bank increases reserve ratio of the commercial banks then banks lack their deposits and issue the less credit. On the other hand, in case of deflation the reserve ratio is decreased so the expansion of credit will occurs.

Market Condition: The market condition can hugely affect the money of supply as well as credit creation in the market. If the market condition is bright then the banks can create more loans at low interest rate by keeping less cash reserve. And, if market is not in bloom condition then banks can increase their interest rate and loans will sanctions in small amount by keeping the cash reserve in high ratio. But all the matters regarding to interest rate and reserve ratio are decide by central bank of the economy.


8


Ali

Loans Sanctions to Non-Bank Financial Institutions: If the transfers of funds (loans) to the non-bank financial institutions but in cash form then it will limit the credit creation ability of the banks. That’s why now the government uses banks for their each and every transaction.

Supply & Volume of Money: The supply & volume of money in the economy is the general parameter which can affect the credit created because the flow of money can basically affect the savings and expenditures of the public. And, the credit creation also plays a vital role to determine the volume of national income and volume of employment in the country.

Will of Borrowers: If the people are illiterate, conservatives and not banked transactional minded in nature then they will never deposit their money in the bank. So, the will of borrowers can adversely affect the process of credit creation. For this purpose government induced the different polices for their employees as well as general public to boost up the banked transaction.

Credit Creation in Pakistan's Economy

Pakistan has turned around a deteriorating macroeconomic situation to a rapidly improving one. In 2004, GDP grew by an estimated 6.4% while inflation rate remained relatively low at 4.6%. These macroeconomic achievements have allowed the country to keep on track towards fiscal consolidation while enabling the government to increase their spending on human capital (education & health care).


9


Ali

The government has also launched far-reaching structural reforms for the private sector, public enterprises, corporative sector, liberalize the external trade, and reforms in banking sector.

By the assistance of World Bank, The Country Assistance Strategy (CAS) has endorsed in 2002 to support the Pakistan's reform program. Under the head of CAS the positives reforms will induces in the total production, growth rate, creating income-generating opportunities, and improving human resources development.

By the designing of CAS, Pakistan gets the al lot of changes and reforms in the macroeconomic policies, business environment, banking sector, cooperate sector and pro-poor and pro-gender policies. Away from all these reforms, the World Bank also supports to Pakistan by CAS forum for deregulation, trade liberalization, tariff reduction, privatization, infrastructure, water, transport, energy and to reduce the cost of doing business in the different fields of Pak-Economy.

The World Bank is also working in cooperation with the International Finance Corporation (IFC) to provide the loans to private sector-lending. For the development of new products IFC & World Bank provides long-term finance options for infrastructure and expanded access to financial services to underserved small and medium enterprises.

Graph of Lending & Deposits in Pak-Economy


10


Ali

Graph of Increase in Interest Rate

Financial Institutes in Pak-Economy


11


Ali

The list of Banks and Financial Developments Institutions in Pakistan which are working in Pakistan to creates the credit in the economy.

Public Sector Commercial Banks

a) First Women Bank Ltd.b) National Bank of Pakistanc) The Bank of Khyberd) The Bank of Punjab

Specialized Scheduled Banks

a) The Punjab Provincial Co-operative Bankb) SME Bank Limitedc) Zarai Taraqiati Bank Limited

Private Local Banks

a) Allied Bank Limited

b) Askari Bank Limited

c) Bank Al-Falah Limited

d) Bank Al-Habib Limited

e) My Bank Limited

f) Creascent Commercial Bank Limited

g) NIB Bank Limited

h) Faysal Bank Limited

i) Habib Bank Limited

j) KASB Bank Limited


12


Ali

k) MCB Bank Limited

l) Meezan Bank Limited

m) Atlas Bank Limited

n) Saudi Pak Commercial Bank Limited

o) Soneri Bank Limited

p) United Bank Limited

q) Arif Habib Bank Limited

r) Dubai Islamic Bank Pakistan Limited

s) Bank Islami Pakistan Limited

t) Royal Bank of Scotland

u) Habib Metropolitan Bank Limited

v) JS Bank Limited

w) Standard Chartered Bank (Pakistan) Limited

x) Emirates Global Islamic Bank

y) Dawood Islamic Bank Limited

Foreign Banks

a) Al-Baraka Islamic Bank B.S.C. (E.C.)b) Citibank N.A.c) Deutshe Bank A.G.d) The Hong Kong & Shanghai Banking Corporation Limitede) Oman International Bank S.A.O.G.f) The Bank of Tokyo – Mitsubishi UJF Limited

Development Financial Institutions

a) Industrial Development Bank of Pakistan Submitted by Ali Raza Sahni

13


Ali

b) Pak Kuwait Investment Company of Pakistan (Pvt) Limitedc) Pak Labya Holding Company (Pvt) Limitedd) Pak Oman Investment Company (Pvt) Limitede) Saudi Pak Industrial & Agricultural Investment Company (Pvt) Limitedf) Pak – Brunai Investment Company Ltd.g) Pak – China Investment Co. Ltd.h) Pak – Iran Joint Investment Co. Ltd.

Micro Finance Banks

a) Khushhali Bankb) Network Micro Finance Bank Limitedc) The First Micro Finance Bank Limitedd) Rozgar Micro Finance Bank Limitede) Tameer Micro Finance Bank Limitedf) Pak Oman Micro Finance Bank Limited

The Money Circulation & Credit Creation in Pakistan

Stock(Rs. millions)

2004 2005 2006 2007 2008 2009

Currency Issued 617508 712480 791834 901401 1054191 119682Reserve by SBP 2960 3107 3006 3148 2900 2689

Currency in Circulation

578116 665901 740390 840181 982325 1128394

Growth Rate (%) 19.6 19.1 15.1 19.3 15.3 1.7Income Velocity

of Money2.4 2.4 2.1 2.0 2.4 -----

Loans Issued 1259085 16806811 2079056 2379226 28099938 3064610


14


Ali

Total Banked Credit

1359009 1801161 2214980 2524932 2950801 3209426

Deposits 1014947 1211674 1350011 2889589 3352974 3234394

Conclusion

In ours overall discussion, we concludes that the credit creation by banks is one of the most important & only one sources to generate income (profit) of banking sector. And the reserve requirements by the central bank directly affect the credit creation. The fact is that all the four players i.e. the central bank, commercial banks, depositors and borrowers are the basic components to determine of credit expansion in the economy.

THE END


Date post:	28-Nov-2014
Category:	Documents
Upload:	ali-raza-sahni
View:	93 times
Download:	3 times

Do Banks Create Credit...?

Documents