Some main limitations on the power of the banks to create credit are discussed below:
The first limitation is the total amount of cash in the country. It may be said that credit can be created only on the basis of cash. Large the cash, large the amount of credit that can be created. But, the amount of cash, which a bank may have is subject to the influence of the central bank which has monopoly on the issue of notes. It may increase it or it may decrease it, and credit will expand or contract accordingly. The power of the central bank to control currency is thus the controlling influence on the extent of credit that the banks have the power to create.
The second limitation arises from the habit of people regarding the use of cash or cheques for their transactions. If people are in the habit of using cash and not cheques, as is the case in India, then as soon as credit is granted by the bank to the borrower, he will draw the cheque and get cash. This will reduce the bank’s cash reserve and its power to create credit is reduced. On the other hand, if people seldom use cash except for very small transactions, then the cash reserve of the banks is not much drawn upon and their power of creating credit remains unimpaired. This is the case in advanced countries like America, England and other European counties. There, the banks hardly keep 10% cash reserve.
The third limitation is the most important one. The power to create credit is also limited by the minimum percentage of cash to deposits which they consider safe. They must maintain a certain reserve ratio of cash to liabilities, to ensure their safety and to retain the degree of liquidity that is considered desirable. It is very simple that when a bank creates credit or grants a loan, it creates obligations that have to be honored. With every increase in its obligation, there is correspondingly a fall in its reserves. The bank will not let the reserve fall below a certain minimum. When that minimum is reached, the power of the bank to create credit comes to an end. The bank will not entertain the idea of granting any further credit, for it will be risky for the bank.
The bank's ability to create credit also depends upon the prevailing business climate. If the economy is going through a period of business prosperity and future profit expectations are bright, the business people would seek more loans from the banks for expanding their activities to earn more profit. This would enable the banks to lend more through credit creation. But, if the economy is passing through a depression and profit expectations are bleak, then banks would find not many borrowers and hence create less credit.
Monetary policy refers to the policy of country’s Central Bank with regard to money supply. If the Central Bank is following a policy aimed at reducing money supply in the market, it will adopt methods and implement measures by which the commercial banks are made to reduce the volume of credit (which is a part of money supply). On the other hand, if the monetary policy is aimed at expansion of money supply, the Central Bank will adopt measures that enable the banks to create more credit. Thus, the monetary policy regulates the overall volume of money supply and credit availability in the economy.SUBMIT ASSIGNMENT NOW!