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Difficulty: MediumCommercial Banks: Functions and Credit Creation

A customer deposits a fresh primary cash sum of ₦400,000\text{₦}400,000 into a commercial bank. If the central bank mandates a legal cash reserve ratio of 12.5%12.5\%, what is the maximum amount of net credit (loans) created by the banking system?

  1. ₦2,800,000\text{₦}2,800,000Answer
  2. B
    ₦3,200,000\text{₦}3,200,000
  3. C
    ₦50,000\text{₦}50,000
  4. D
    ₦3,600,000\text{₦}3,600,000

Answer

The maximum net credit created by the banking system is ₦2,800,000\text{₦}2,800,000.
With a cash reserve ratio of 12.5%12.5\%, the credit multiplier is 10.125=8\frac{1}{0.125} = 8. Total deposit expansion generated across the banking system is ₦400,000×8=₦3,200,000\text{₦}400,000 \times 8 = \text{₦}3,200,000. To determine net credit (loans) created, the initial primary deposit of ₦400,000\text{₦}400,000 must be subtracted from total deposits, resulting in ₦2,800,000\text{₦}2,800,000.

Step-by-Step Solution

1
Calculate the credit multiplier (KK).
K=1Cash Reserve Ratio=10.125=8K = \frac{1}{\text{Cash Reserve Ratio}} = \frac{1}{0.125} = 8.
The credit multiplier determines the total potential deposit expansion from a primary deposit.
2
Calculate total deposit expansion.
Total Deposits=Initial Deposit×K=₦400,000×8=₦3,200,000\text{Total Deposits} = \text{Initial Deposit} \times K = \text{₦}400,000 \times 8 = \text{₦}3,200,000.
Total deposits reflect the overall expansion in the banking system through secondary deposits.
3
Calculate net credit (loans) created.
Net Credit=Total Deposits−Initial Deposit=₦3,200,000−₦400,000=₦2,800,000\text{Net Credit} = \text{Total Deposits} - \text{Initial Deposit} = \text{₦}3,200,000 - \text{₦}400,000 = \text{₦}2,800,000.
Net credit created equals total new deposits minus the original primary cash deposit introduced.

Key Concept

Commercial Bank Credit Creation and Credit Multiplier
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Topics

Commercial Banks: Functions and Credit Creation