Commercial bank is a licensed financial institution that was incorporated in order to carry out the financial transactions as mentioned in Chapter 7 section 49(1) of Bank and Financial Institution Act, 2073. Reasons to call commercial banks as Factories of Credit creation are as follows;
Reasons to call Factories of credit creation
The process of credit creation is said to be one of the most important functions that is performed by the commercial bank.
Money supply cannot be handling by the central bank alone, for this course of action; they require commercial bank help and their reserve.
In the credit process, the commercial bank facilitates the loans by utilizing the deposit that is obtained from the general public as a deposit. For example; If the banks success in creating Rs 1000 out of primary deposit of Rs 100, the bank has crested 10 times money of that deposit.
The commercial banks create credit when it buys securities and pays the seller with its own cheque. The cheque is deposited in some bank and a deposit is created for the seller of the security, as a result of credit creation, money supply in the economy becomes higher.
Symbolically it can be understood or expressed as 1/r; where ‘r’ is a reserve ratio.
It is because of this credit creation power of commercial banks are called factories of credit or manufacturer of money.
Factors that affect the process of credit creation
Bank cannot expand deposit by granting loans and advances unless proper securities are available in the market.
Loans are taken only when sound investment opportunities are available.
Total amount of cash available to commercial bank limits the volume of credit that can be created.
In developing countries like Nepal, people prefer cash in hand due to financial illiteracy what reduces the power of commercial bank to create credit.
Some borrowers may keep a part of their money in hand without putting it in the bank that limits cash to create credit.
The policy regarding open market operation etc may affect the total cash reserve of the commercial banks and may make the total credit less or more than what it would be.
