With intro and usage of money, credit likewise originated. Credit is produced when one party (it can be person, group of people, firm or an institution) provides cash to another party, the customers. The act of borrowing develops both credit and debit. Financial obligation implies the commitment to pay the finance obtained and credit means the claim to get this money payment from the other party. Every credit includes debt, that is responsibility to pay money and for that reason creates claim.
Definition of crucial terms
Credit is normally comprehended to imply the financing provided to others at certain rate of interest (Mudida 2003). The act of borrowing and lending and there by the creation of credit is an unique kind of exchange transaction which includes future payments of the concept amount obtained as well as interest rate on it. The financing and loaning of cash and institution of cash providing entered practice considering that cash was welcomed by male (ibid).
Commercial Bank is a company which handles money, it obtain and lend money in with purpose of producing revenue Ahuja 2008).
Central Bank, Reserve Bank or Monetary
Authority is a public institution that handles a state’s currency, cash supply, and interest rates. Reserve banks also usually oversee the industrial banking system of their particular countries. In contrast to a commercial bank, a reserve bank has a monopoly on increasing the country’s monetary base, and generally also prints the nationwide currency, which normally serves as the nation’s legal tender (www.en.wikipedia.org).
HOW BANKS PRODUCE CREDITS
The source of money supply in the type of currency is blood circulation in Reserve bank. It ensures the availability of currency to satisfy the deal needs of the economy. The overall volume of cash in the economy must be adequate to assist in the numerous types of financial activities such as production, circulation and usage.
The commercial banks are the second most important source of money supply. The money that commercial banks supply is called credit money. The process of credit creation begins with banks lending money out of primary deposits. Primary deposits are those deposits which are deposited in banks. Bank cannot lend entire primary deposits as they are required to maintain a certain proportion of primary deposits in the form of reserve with the Central bank and Banking regulation act. After maintaining the required reserves, the bank can lend the remaining portion of primary deposit and here the process of credit creation starts.
Suppose there are a number of commercial Banks in the banking system – Bank 1 is required to maintain a cash reserve at let say 10% (which is decided by BoT). Bank one has to keep 1000 which is 10% of TZS10000. The remaining TZS9000 can be lent to another customer let say b, where bank 1 will open an account in the name of borrower cheque for the loan amount. At the end of deposits and lending, the balance sheet of bank 1 will be as follows:-
The amount advanced to D will return ultimately to the banking system as described in case of B and process of deposits and credit creation will continue until the reserve with banks is reduced to zero. The final picture that would emerge at the end of the process of deposits and credit creation by the banking system is presented in the consolidated balance sheet of all banks are as below:-
It can be seen from the combined balance sheet that a primary deposits of TZS10000 in a bank 1 leads to the creation of the total deposit of TZS100000. The combined balance sheet also shows that the banks have created a total credit of TZS100000 and maintained a total cash reserve of TZS10000 which equals the primary deposits. The total deposit created by the commercial banks constitutes the money supply by the banks.
This process can be explained with a formula
Total credit created = Original deposit x credit multiplier co-efficient. Credit multiplier co-efficient = 1/CRR = 1/10% = 1/10/100 = 10 CCR = Cash Reserve Ratio (10%)
Total credit created = 10000 x 10 = 100000
NB: For the case of Tanzania, the reserve ratio (CRR) is 10% it may differ with other countries, for stance, India is 5%. The higher the CCR the lower the credits will be created and vice versa.
FUNCTIONS OF CREDITS
Credits play important roles in the economy, for as we all know that resources are scarce, it is impossible for a firm to have abundant of resources so in solving this problem of scarcity, individuals may opt to find loans or credits from various sources. Credits can be important in the following ways; Helps in transfer of money (resources) from those with surplus to those with deficit and want to spend more than they have. This help to relieve the constraint imposed by balanced budget on economic agent, to the financial requirement of investors who have to spend more on trade and investment than their own savings.
It ensures better allocation of financial resources and there by encourage economic growth in the economy.
Credit is of outstanding significance in the modern economic system. It plays a vital role in business finance. A major portion of the capital, particularly short-term capital is provided on credit.
There is no question that credit can provide a smoother flow of money through an economy to ensure that periodic starts and stops are not affected by variations in the cash flow. This is particularly important to ensure smooth operation in many companies as well as for individuals.
Furthermore, Purchasing Assets is one of the primary functions of loans is to help borrowers purchase assets. For individuals, this usually means buying a piece of property or a car or a similar large purchase. Businesses, on the other hand, have a wide variety of assets that they need, ranging from factory equipment to expensive computer software and hardware. Both individuals and organizations usually need to take out loans to buy these larger assets.
In addition to that, credit helps in Investment; loans are made specifically for investment in stocks, bonds or other types of securities. Investment loans can come from a variety of sources. Sometimes brokerage firms will make loans available to investors so they can purchase extra securities. At other times, banks will make investment loans themselves, especially to businesses that are interested in growth or acquisitions.
LIMITATIONS OF CREDIT CREATION
The followings are the limitations or problems in credit creation; Amount of Cash: The power to create credit depends on the cash received by banks. If banks receive more cash, they can create more credit. If they receive less cash they can create less credit. Cash supply is controlled by the central bank of the country.
Cash Reserve Ratio: All deposits cannot be used for credit creation. Banks must keep certain percentage of deposits in cash as reserve. The volume of bank credit depends also on the cash reserve ratio the banks have to keep. If the cash reserve ratio is increased, the volume of credit that the banks can create will fall. If the cash reserve ratio is lowered, the bank credit will increase. The Central Bank has the power to prescribe and change the cash reserve ratio to be kept by the commercial banks. Thus the central bank can change the volume of credit by changing the cash reserve ratio.
Banking Habits of the People; the loan advanced to a customer should again come back into banks as primary deposit. Then only there can be multiple expansions. This will happen only when the banking habit among the people is well developed. They should keep their money in the banks as deposits and use cheques for the settlement of transactions.
Nature of Business Conditions in the Economy: Credit creation will depend upon the nature of business conditions. Credit creation will be large during a period of prosperity, while it will be smaller during a depression. During periods of prosperity, there will be more demand for loans and advances for investment purposes. Many people approach banks for loans and advances. Hence, the volume of bank credit will be high. During periods of business depression, the amount of loans and advances will be small because businessmen and industrialists may not come to borrow. Hence the volume of bank credit will be low (Maliyamkono, and Bagachwa, 1990).
Leakages in Credit-Creation: There may be some leakages in the process of credit creation. The funds may not flow smoothly from one bank to another. Some people may keep a portion of their amount as idle cash.
The central bank of a country has responsibility of controlling the volume and direction of credit in the country. Bank credit has become these days an important constituent of the money supply in the country. The volume and direction of bank credit has an important bearing on the level of economic activity. Excessive credit will tend to generate inflationary pressure in the economy while deficiency of credit supply may tend to cause depression of deflation. Therefore, there must be balance in credit creation in order to have strong and growing economy.
- Ahuja H. L (2009); Macroeconomic Theory and Practice, 15th Revised edition, Rajendra Ravinda Printers PVT Ltd. New Delhi. Mudida, R. (2003). Modern Economics: Nairobi Focus publication Ltd. Maliyamkono, T.L. and M.S.D. Bagachwa, (1990), The Second economy in Tanzania Villiers Publications, London.
Cite this essay
Bank Credits’ Role In The Economy. (2016, Nov 11). Retrieved from https://studymoose.com/bank-credits-role-in-the-economy-essay