Commercial Banks though have the power to create credit, their powers are not unlimited. Certain points affect the process of credit creation. They are termed as limitations to credit creation by commercial banks.
The limitations of credit creation by commercial banks are as follows :-
1. Amount of Deposit
The most important factor which decides credit creation is the amount of deposits made by the depositors. Higher is the amount of deposits, greater is the supply of credit and vice versa.
2. Cash Reserve Ratio (CRR)
There exists an indirect relationship between Credit Creation and Cash Reserve Ratio (CRR). Higher is the Cash Reserve Ratio (CRR) more will be the reserves to be maintained and less credit will be created by banks. The CRR is fixed by the RBI in India. It ranges between 3% to 15%.
3. Banking Habits of People
If the banking habits of the people are well-developed, then all their transactions would be through banks, and this will lead to expansion of credit and vice-versa.
4. Supply of Securities
Loans are sanctioned on the basis of the securities provided to the banks. If securities are available then the credit creation will be more and vice-versa.
5. Willingness of people to borrow
Commercial banks may have enough money to lend. Customers should be willing to borrow from the banks to facilitate credit creation. If they are willing to borrow, then the credit created by banks will be less.
6. Monetary Policy of Central Bank
While credit is created by commercial banks, it is controlled by the Central Bank. Credit control is one important function of the central bank. Central Bank uses various methods of Credit Control from time to time and thus influences the banks to expand or contract credit.
7. External Drain
External Drain refers to withdrawal of cash from the banking system by the public. It lowers the reserves of the banks and limits the credit creation.
8. Uniform Policy
If all the commercial banks follow a uniform policy related to CRR, then credit creation would be smooth. If some banks follow liberal and others follow a conservative one, then credit creation would be affected.