Question

State with reason whether you 'agree' or 'disagree' with the following statement.

Credit creation of commercial banks is based on primary deposits.

Options

• Agree 

• Disagree

Answer 1

Ans. I do agree with the statement. This is because.

Credit Creation :

The main source of funds, which is available to commercial banks, is in the form of deposits from the public.

 

Primary Deposits :

Primary deposits are also known as cash deposits. Such deposits refer to money deposited by the people in the form of cash with the banks. These deposits are withdrawable by the depositors.

A part of these deposits are kept by the bank, to meet the demand for cash of the depositor. This is termed as minimum cash reserves. The banks are able to do with a very small reserve because all depositors do not withdraw money at the same time.

 

For example, let us suppose that every bank has to keep 20%, of its deposits as cash reserve and advances loans from 80% of its deposits. Bank 'A' receives a primary deposit of Rs. 10,000/- retains, 20% as cash reserve and lends Rs. 8,000/- to a businessman who deposits it in bank Rs. B'. The bank 'B' would lend Rs.  6,400/- after retaining Rs. 1,600/- The amount of Rs. 6400/- is deposited in bank 'C', which retains Rs. 1,280/- and lends Rs. 5,120/-. The amount Rs. 5120/- is deposited in bank 'D'. The bank D would lend Rs. 4096/- after retaining Rs. 1024/-. This process ends at the stage where the subsequent banks receive too small amount as primary deposit to advance any loans from it. The following table summaries this process.

 

Banks	Primary Deposit	Reserves	Secondary Deposits	Loans
A	10000	2000	8000	8000
B	8000	1600	6400	6400
C	6400	1280	5120	5120
D	5120	1024	4096	4096