Process of credit creation: It is often said “Loans create deposits and deposits create loans.” 

The statement can be explained as:

We assume, a situation in an economy where one bank ‘A’ receives a primary cash deposit from a person. After maintaining the Cash Reserve Ratio (CRR) with the central bank, the bank is left with the deposit of say Rs 1000. Assuming that the Statutory Liquidity Ratio (SLR) is 10% of bank deposits, kept reserved for daily transactions, withdrawal etc. So the loanable fund with bank A becomes Rs 1000 – Rs 100 = Rs 900.

A second person now comes to bank A with a loan requirement. The maximum amount of loan can be Rs 900. However, bank A instead of providing cash loans will ask the person to open an account with the bank and provide him with the facility of drawing checks to the amount of Rs 900. The second person after taking the loan, hands over the cheque to a third person who deposits the cheque in his own bank B. Thus a loan of Rs 900 creates a derivative, deposit of the same amount in bank ‘B’, bank ‘B’ can in-turn lend to a third person a maximum of Rs 810 (Rs 900 – Rs 90). In this way in the subsequent stages, the derived deposits in the other banks reduce and the total volume of credit expands. The process continues until the loanable amount becomes negligible. Given SLR, mathematically the commercial banks jointly create a total volume of credit a multiple of the reciprocal of SLR, i.e.,

Volume of total credit = Primary deposit x \(\frac{1}{SLR}\)

\(\frac{1}{SLR}\) is known as the credit multiplier.

Alternatively, total volume of credit creations = 1000 + 900 + 810 + 729 + …….

This is an infinite GP series = \(\frac {1000}{1- 0.9} \) = 10,000

Here, the whole banking sector is to be taken into account and good banking habits are to be inculcated among the citizens.