Credit Creation by a Thrissur Cooperative Bank
A district cooperative bank in Thrissur receives a fresh deposit of ₹50 crore from a newly opened coconut-processing company. The bank is already fully loaned up and has no excess reserves. The RBI's cash reserve ratio is 4 per cent and the statutory liquidity ratio is 18 per cent. The bank's managers argue that because they must also hold SLR securities, the deposit will create far less credit than the textbook multiplier suggests. The public is assumed to hold no additional currency, and all borrowers keep their accounts within the same banking system. The RBI then announces an increase in the cash reserve ratio to 5 per cent to contain inflation. A trainee officer is asked to calculate deposit expansion under the original CRR, under a situation where banks voluntarily hold excess reserves of 1 per cent, and after the CRR increase.
1. Calculate the deposit multiplier and total deposit creation from the ₹50 crore fresh deposit under CRR 4 per cent, assuming no excess reserves and no currency leakage.
Read the worked answer
The simple deposit multiplier is:
m = 1 / CRR = 1 / 0.04 = 25
Total deposits created in the banking system = fresh deposit × multiplier = ₹50 crore × 25 = ₹1,250 crore.
Credit created = total deposits − initial deposit = 1,250 − 50 = ₹1,200 crore. The process works in rounds: the first bank keeps 4 per cent of ₹50 crore (₹2 crore) as reserves and lends ₹48 crore; the borrower deposits ₹48 crore in another bank, which keeps ₹1.92 crore and lends ₹46.08 crore, and so on. The sum of the geometric series is ₹1,250 crore. SLR does not enter this simple reserve multiplier because SLR is held in approved securities, not as cash reserves; it does, however, affect the composition of bank assets and the funds available for lending.
2. Recalculate the expansion if banks voluntarily hold excess reserves of 1 per cent of deposits. Why might actual expansion be even lower?
Read the worked answer
The effective reserve ratio becomes CRR + excess reserve ratio = 4% + 1% = 5%.
New multiplier = 1 / 0.05 = 20.
Total deposits = ₹50 crore × 20 = ₹1,000 crore; credit created = ₹950 crore.
Actual expansion may be lower still because the assumptions are restrictive. The public may hold part of the loan money as currency, so not every rupee returns to the banking system. Banks may be unwilling to lend if they fear bad loans or if credit demand is weak. Borrowers may use loans to repay old debts or to buy foreign exchange, and some deposits may leak out of the domestic banking system. The textbook multiplier therefore gives an upper limit, not a forecast.
3. After the CRR is raised to 5 per cent, calculate the new multiplier and total deposits. Explain how this affects credit and the macroeconomy.
Read the worked answer
With CRR = 5 per cent and no excess reserves, multiplier = 1 / 0.05 = 20.
Total deposits from the same ₹50 crore fresh deposit = ₹50 crore × 20 = ₹1,000 crore, compared with ₹1,250 crore before. The contraction is ₹250 crore of deposits and, correspondingly, less credit.
A higher CRR locks a larger fraction of deposits with the RBI, reducing lendable funds and usually raising the cost of credit. Slower credit growth can moderate aggregate demand and inflation, but the strength of the effect depends on whether banks already hold excess reserves, how sensitive borrowers are to interest rates, and whether credit demand is weak. If banks are already cautious, a CRR hike may mainly reduce their reserves rather than their lending.