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Difficulty: MediumCommercial Banks: Functions, Services, and Credit Creation

A customer deposits N400,000\text{N}400,000 in cash into a commercial bank. The Central Bank mandates a Cash Reserve Ratio (CRR) of 20%20\%, and the bank voluntarily retains an additional 5%5\% of deposits as an extra liquidity reserve to meet daily withdrawals. Assuming all remaining cash reserves are fully re-lent throughout the banking system, what is the maximum amount of derivative deposits that can be created?

  1. N1,200,000\text{N}1,200,000Answer
  2. B
    N1,600,000\text{N}1,600,000
  3. C
    N1,600,000\text{N}1,600,000 (calculated without liquidity reserve)
  4. D
    N100,000\text{N}100,000

Answer

The maximum amount of derivative deposits created is N1,200,000\text{N}1,200,000.
The effective reserve ratio is 25%25\% (0.250.25), yielding a credit expansion multiplier of 44. The overall deposit liabilities created total N1,600,000\text{N}1,600,000. Subtracting the initial cash deposit of N400,000\text{N}400,000 yields N1,200,000\text{N}1,200,000 in derivative deposits.

Step-by-Step Solution

1
Calculate the total effective reserve ratio.
Total Reserve Ratio (rr) = Statutory Cash Reserve Ratio (20%20\%) + Voluntary Liquidity Reserve (5%)=25%=0.255\%) = 25\% = 0.25.
Both statutory reserves and voluntary liquidity cushions restrict the proportion of deposits available for lending.
2
Determine the credit expansion multiplier.
Credit Multiplier (KK) = 1r=10.25=4\frac{1}{r} = \frac{1}{0.25} = 4.
The deposit multiplier is the reciprocal of the total reserve ratio.
3
Calculate total deposit expansion in the banking system.
Total Deposit Expansion = Primary Deposit ×K=N400,000×4=N1,600,000\times K = \text{N}400,000 \times 4 = \text{N}1,600,000.
Multiplying the initial primary deposit by the multiplier gives the total capacity of credit and deposit generation.
4
Isolate the derivative deposits generated.
Derivative Deposits = Total Expansion - Primary Deposit = N1,600,000−N400,000=N1,200,000\text{N}1,600,000 - \text{N}400,000 = \text{N}1,200,000.
Derivative deposits represent secondary credit created by commercial banks beyond the original cash injection.

Key Concept

Credit Creation and Derivative Deposits
Estimated Time:1m 30s
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Topics

Commercial Banks: Functions, Services, and Credit Creation

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