People keep their deposit in the bank. The bank gives interest on them. The bank has to earn in order to pay. The lend credit for all types of investment. Word credit is derived from the Latin word “credo”. It means “I believe”. The depositor believes that the bank shell pays him on demand. The bank believes that he will not turn up to withdraw his entire mount. It believes that the debtor shall pay off the debt in time with interest.

The deposits of the people are called primary deposits. What the bank keeps to meet the demand of the depositor is called “Cash Reserve”. The excess of the primary deposits is called secondary deposits. Secondary deposits are the created credit. Every deposit creates credit and every credit creates deposits. The bank never lends cash. It always authorizes the borrower to draw upon it with cheques. All type of transaction is undertaking with cheques and drafts etc. Every person getting the loan does the business with another person. The businessman gets the payment in cheques. He deposits the cheques with the bank. It gets the power to create the more credit on this basis. The size of the credit depends upon the Cash Reserve Ratio. Higher cash reserve ratio creates lesser credits while lower ratio creates more credit. Any with drawl are decrees in the primary deposits will decrease the credit-creating capacity. It is not as the destruction of credits.

Limitation

The credit-creating capacity of the bank is not unlimited. There are certain limitation it creation of credit. They are as follow:

Size of the Deposit

The size of the primary deposit determines. The capacity of the bank to creates the credit. Increase in the deposit increases the capacity of the bank. The decrease in it decreases the capacity.

Reserve Ratio

Cash reserve ratio is a check on the capacity in the creation of credit by a bank. Higher reserve ration lowers of credit. This ratio is mostly determined by the central bank of the country. Lower reserve ratio expands the creation of credit.

Demand for Loan

The bank may have a big primary deposit. They are useless as there is no demand for them form the people. The demand for the loan is always for investment. People demand loans when there is political, social and economic peace in the country. Any unrest will badly affect the demand for loan. It main the bank has not free hands to create on expands the money.

Collateral Securities

The bank always lends against collateral securities. They are in form of moveable and unmovable property. Their size remains the same in the short period. The credit-creating capacity of the bank is limited to the size of the collateral securities.