Bank create credit / What are the limitations
Credit means availing the benefits of purchasing an asset without paying for the same.
Classification of Credit
Following are the classification of credit:
1. Mercantile credit: Mercantile credit, sometimes also called as commercial credit, can be described as that type of credit which one businessmen extends to another when selling goods for resale or for commercial use, to a transaction involving the use of mercantile credit may be merchant distributors like wholesalers, jobbers, and producers or manufacturers. The essential characteristic of mercantile credit is that it is an exchange of goods for the purpose of sale.
Mercantile credit may be distinguished from consumer credit in the sense that the former is brought about by transactions involving transfers of goods for business purposes, unlike the latter, which is intended specifically for consumption purposes.
2. Commercial Bank Credit: Bank credit refers solely to the credit given by commercial banks to businessmen to assist them in the operation of their business. Businessmen, require loans for a number of purposes for instance, the financing or in the transaction of or for the purpose of production, in the storage or in the transportation of, or for the purchase of raw materials.
3. Commodity Loans: Since most agricultural product are produced annually and are harvested and available for the market within the span of transportation, storage, financing and marketing.
Many such commodities are stored in cold storage warehouse which store the perishable goods. The warehouse is required to be license to issue negotiable receipt, to meet all specification as to financial stability, inspection to furnish such security bond coverage, etc. In most instances the receipt of an approved warehouse can be readily accepted for collateral purposes and loans can be given on the security of these receipts.
4. Export Credit: As is generally observed, export trade may be pushed by means of extension of credit to buyer, as is the common practice, but before the buyer takes possession of them. Still, export sales can be done on the basis of payment when the goods are shipped through cash deposit by the buyer or bank guarantees and particularly by letters of credit and the use of drafts.
5. Industrial credit: It is intended to finance needs of industries like logging, fishing, manufacturing and others, and which involves big amounts of money. Generally speaking, as may be expected, the maturity of this type of credit is long term.
6. Real Estate credit: When credit is purposely for construction, acquisition, expansion or improvement of real estate properties, it is termed as real estate credit. According to maturity credit may be classified as: short, medium, or intermediate, and long term.
(a) Short-term credit: Is payable within one year from the date of acquisition. This type of credit usually covers the purchase of consumers’ goods.
(b) Medium or intermediate term credit: This credit ranges from one year to five years in maturity. This is usually given for the number or purposes, like the financing of improvements on a firm or industry.
(c) Long-term credit: This credit has a repayment period of beyond five years. This type of credit covers those loans intended for investment purposes.
Credit Creation
Creation of credit is one of the most outstanding functions of a modern bank. A bank has sometimes been called a factory for the manufacture of credit.
How credit is created? It is an open secret that the banks do not keep cent percent reserve against deposits in order to meet the demands of depositors. It is generally understood that money received by the bank is meant to be advanced to others. A depositor has to be content simply with the bank’s promise or undertaking to pay him whenever he makes a demand. This the banks are able to do with a very small reserve, because all the depositors do not come to withdraw money simultaneously; some withdraw, while others deposit at the same time. The bank is thus enabled to erect a vast superstructure of credit on the basis of a small cash’ reserve. The bank is able to lend money and charge interest without parting with cash, as the bank loan creates simply a deposit, or it creates a credit for the borrower. This is what is meant by creation of credit. Let us see the actual process.
Let us assume that there is only one bank in the country. Suppose a customer deposits 1,000 in the bank.
Suppose the bank, in which a depositor has deposited 1,000, keeps 20 percent cash reserve to meet the demand of depositors. This means that, as soon as the bank has received 1,000 it will make up its mind to advance 800 as loan. This 800 will be advanced to a customer by depositing it to his account. So, this results in a fresh deposit of 800. Out of this deposit, the banks will further advance 640 as loan. This process will continue upto a point when the Banks advance loans upto 5000 (1000+0.2).
Thus the bank has succeeded in creating a credit of 5,000 against a cash reserve of 1,000.
Factors Affecting the Volume of Credit/ Limitations of Credit Creation
The following are the limitations on the power of a commercial banks to create credit:
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,
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. If proper securities are not available with the public, a bank cannot create credit.
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 banking system. This reduces the power of banks to create credit to the desired level.
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 creates credit. The higher this ratio, the lower the power of banks to create credit; and the lower the ratio, the higher the power of banks to create credit.
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 25 per cent of 1000 instead of 20 per cent, it will lend 750 instead of 800. Consequently, the amount of credit creation will be reduced.
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, limits the power of the banking system to create credit
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 of the part of banks. Accordingly, the credit creation stream is disturbed.
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.
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.
