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Creation of Credit

Creation of credit is considered as a major function of the commercial banks. As financial intermediaries, commercial banks reap a rich harvest which they have not sown. They are in a position to do so by extending loans and advices to their customers out of the deposits left with them.

A prudent banker by his experience and following the law of averages knows that on no single day or at any one time during his working hours on any day all of his depositors will be calling upon him to withdraw their deposits. Deposits are, undoubtedly bankers’ liabilities to his depositors which must be honored on demand. A bank which refuses to do so or is unable to do so will soon find his cash base eroding away, his solvency having been put in doubt and public’s confidence in him shaken. A vigilant banker cannot afford to run this risk.

But, at the same time, since he knows that he is not going to be called upon to honor all of his liabilities simultaneously he cannot afford to keep his reserves idle. For one thing cash is barren asset that does not bring in any income to the banker; second he is to pay interest to his depositors and also meet various administrative expenses besides earning enough residual of shareholders of the bank. Thus, the banking business is such that no banker can afford to deep idle cash reserves with himself.

By his experience he knows that he can safely extend loans and advances, charge interest from his debtors, pay a part of income so realized to his depositors in the form of interest on their deposits, and after meeting the administrative expenses, earn a residual for his shareholders. As a matter of fact, he is in a position to extend loans and advances equal in value of his initial cash reserves but equal to a multiple times of the value f his reserves.

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