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Limitations of Credit Creation - Credit Creation, Indian Financial System | Indian Financial System - B Com PDF Download
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.
Question for Limitations of Credit Creation - Credit Creation, Indian Financial SystemTry yourself: What is the most important factor that determines credit creation by commercial banks?View Solution
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.
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| 1. What are the limitations of credit creation in the Indian financial system? |  |
Ans. Credit creation is a crucial aspect of the Indian financial system, but it also has its limitations. Some of the limitations of credit creation in the Indian financial system are:
1. Legal Reserve Requirements: Banks are required to maintain a certain percentage of their deposits as reserves, which limits their ability to create credit.
2. Creditworthiness of Borrowers: Banks need to assess the creditworthiness of borrowers before extending credit. This limits the amount of credit that can be created.
3. Economic Conditions: Economic conditions such as inflation and recession can impact credit creation, as banks may become more cautious in extending credit during uncertain times.
4. Central Bank Policies: Central bank policies such as changes in the interest rates and reserve requirements can limit credit creation.
5. Competition: Competition within the banking industry can also limit credit creation, as banks may not be able to extend credit to all potential borrowers due to limited resources.
| 2. How does legal reserve requirements limit credit creation? | |
Ans. Legal reserve requirements are one of the limitations of credit creation in the Indian financial system. Banks are required to maintain a certain percentage of their deposits as reserves, which limits their ability to create credit. For example, if a bank has Rs. 100 in deposits and the reserve requirement is 10%, then the bank can only lend Rs. 90. This reduces the amount of credit that can be created, as banks need to hold a certain amount of reserves to meet withdrawal demands.
| 3. How can economic conditions impact credit creation? | |
Ans. Economic conditions such as inflation and recession can impact credit creation in the Indian financial system. During inflationary periods, banks may become more cautious in extending credit as they may face higher default risks. At the same time, during a recession, banks may reduce their lending as they may face increased credit risks. These factors can limit the amount of credit that banks can create, as they need to balance their risk and reward.
| 4. How do central bank policies impact credit creation? | |
Ans. Central bank policies can impact credit creation in the Indian financial system. For example, if the central bank increases the reserve requirement, banks will need to hold more reserves, which limits the amount of credit they can create. Similarly, changes in interest rates can impact credit creation, as higher interest rates may reduce the demand for credit. Central bank policies can also impact the creditworthiness of borrowers, as changes in interest rates can impact their ability to repay loans.
| 5. How does competition limit credit creation? | |
Ans. Competition within the banking industry can limit credit creation in the Indian financial system. Banks may not be able to extend credit to all potential borrowers due to limited resources. This can result in credit being extended to only the most creditworthy borrowers, which limits the overall amount of credit that can be created. Additionally, competition can also impact the interest rates offered by banks, which can impact the demand for credit.
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