THE DYNAMICS OF CREDIT CREATION IN NIGERIAN COMMERCIAL BANKS

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Lesson Objectives

By the end of the lesson, students should be able to:

1. Explain basic steps of credit creation
2. List the major limitations to credit creation by commercial banks.
3. Identify and explain common problems faced by commercial banks in Nigeria.

What is Credit Creation?

Credit creation is when banks increase the amount of money available in the economy.

Banks create credit through:

Accepting Deposits:

The first step in credit creation is accepting deposits from customers. When people and businesses keep their money in the bank, the bank does not leave all the money idle. Instead, deposits become the foundation on which the bank can create credit. These deposits form the pool of funds from which the bank can lend. The important thing here is that most depositors do not withdraw all their money at the same time, so banks can safely use a large part of the deposits to give out loans.

Keeping Only A Small Part As Cash Reserve:

Banks are required to keep a small percentage of their deposits as a reserve. This reserve is held to meet the day to day withdrawal needs of customers. The central bank often gives guidelines on how much reserve each bank must keep. By holding only a fraction of deposits as reserves and not the full amount, banks are able to use the remaining funds to grant loans. This fraction of money kept increases the bank’s ability to create credit from deposits.

Lending Out The Remaining Portion Of Deposits:

After keeping the required reserve, the bank lends out the rest of the deposits to individuals and businesses. When the bank gives a loan, it does not always hand out physical cash. Instead, it often credits the borrower’s bank account with a deposit. This action creates new money because the borrower can now spend money that did not previously exist in the system. As loans are given out, the amount of money available in the economy increases.

Borrowers Spend The Loan And It Returns To The Banking System:

Once borrowers receive their loans, they use the money to pay for goods, services, or investments. The people who receive this money then deposit it back into their own bank accounts. This means that the money loaned out finds its way back into the banking system. When the money returns as new deposits, the bank, or other banks, can again keep a small reserve and lend out the rest. This cycle allows the banking system to multiply the original deposit several times.

The Process Repeats And Expands The Money Supply:

The cycle of deposit, reserve, and lending repeats continuously. Each time the money is re-deposited, the bank can lend out a portion again and again. This repeated process increases the total amount of money in the economy far beyond the original deposit. This is known as the credit multiplier effect. It is through this continuous and repeated lending process that commercial banks create credit and expand the money supply.

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Limitations To Credit Creation By Nigerian Commercial Banks

There are certain factors that reduce the ability of banks to create credit.

These include:

• Amount of Cash in the Economy: The amount of cash available to commercial banks strongly affects how much credit they can create. Banks need cash to meet customers’ daily withdrawal demands, so when cash is limited, they are forced to hold back on lending. If customers withdraw a large portion of their deposits, the bank has less money left to lend out. This reduces the bank’s ability to extend credit to businesses and individuals. In an economy where cash supply is tight, credit creation falls because banks must operate cautiously to avoid running out of liquid funds.
• Legal Reserve Requirements: Every commercial bank must keep a portion of its deposits with the central bank. This is known as the legal reserve requirement. The higher the reserve ratio, the less money the bank can lend out. Since credit creation depends on the ability to loan out deposited funds, a strict reserve requirement limits this process. If the central bank raises the reserve ratio, banks have to keep more money idle, which slows down credit creation. On the other hand, a lower reserve ratio gives banks more freedom, but they still cannot ignore the legal requirement.
• Demand for Loans: Credit creation only happens when people and businesses borrow money. If there is little demand for loans, commercial banks cannot create credit even if they have enough funds. During periods of economic slowdown, when people cut back on spending and businesses delay expansion, loan demand falls. This reduces the bank’s ability to create credit. Even when interest rates are low, loan demand may still be weak if borrowers lack confidence in the economy.
• Availability of Good Collateral: Banks lend out money only when they are sure that borrowers can repay. One way they guarantee this is by requesting collateral. If borrowers cannot provide acceptable collateral such as land, buildings, or valuable goods, the bank may refuse the loan. This limits credit creation because the bank cannot safely lend money to borrowers who are considered risky. The presence of poor or insufficient collateral increases the bank’s fear of loan default, which reduces its willingness to create credit.
• Central Bank Controls: The central bank regulates the activities of commercial banks to maintain a stable financial system. It may raise interest rates, tighten lending rules, or increase reserve requirements to control inflation or manage economic conditions. These measures make it harder for commercial banks to grant loans. When borrowing becomes expensive or rules become strict, fewer people apply for loans and banks become more cautious. As a result, credit creation is reduced.
• Public Confidence in Banks: Public trust plays a major role in credit creation. People must feel safe keeping their money in banks. When confidence is high, customers deposit more money, giving banks the resources to create credit. However, when people fear that banks might fail or face financial trouble, they withdraw their savings. This reduces the bank’s deposit base and limits how much money it can lend out. Instances of fraud, bank failure, or poor customer service can weaken public confidence and slow down credit creation.
• Economic Conditions: The state of the economy influences credit creation. During periods of economic growth, businesses expand and people feel more confident in borrowing. This leads to higher credit creation. However, during recessions or periods of inflation, banks face more risks. Borrowers may struggle to repay loans and banks become more cautious. High inflation also makes long term lending risky. Poor economic conditions therefore reduce the willingness of both banks and customers to participate in credit transactions, limiting credit creation.

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Problems of Commercial Banks in Nigeria

Commercial banks in Nigeria face many challenges that affect their operations.

Common problems include:

• High Rate of Loan Default: Many customers who borrow money from commercial banks do not repay their loans on time. Some do not repay at all. This reduces the amount of money the bank has to lend to others. When banks lose money through unpaid loans, they become more careful and may stop giving credit to genuine customers. Loan default also increases the bank’s cost of recovering debts through legal actions, which slows down economic growth.
• Fraud and Cybercrime: Fraud is a major challenge in the Nigerian banking sector. Criminals use fake documents, stolen identities or insider information to steal money from banks and customers. Cybercrime has also grown due to the widespread use of online banking. Hackers attempt to break into bank systems and transfer money illegally. Banks spend a lot on security systems to protect accounts, which increases their operating costs.
• Poor Infrastructure: Many commercial banks struggle because of poor infrastructure in Nigeria. Issues such as unstable electricity supply, slow internet connection and poor road networks make banking operations difficult. Banks need steady electricity to run ATMs, computers and servers. When there is no power, services are interrupted and customers become dissatisfied. These problems increase operating costs and delay banking services.
• Economic Instability: Nigeria’s economy is often affected by inflation, unemployment and fluctuating oil prices. When the economy is unstable, people save less money and businesses borrow less. This reduces the ability of commercial banks to collect deposits and give loans. A weak economy also increases the risk of loan default because borrowers may lose their source of income. Economic instability makes planning difficult for banks.
• High Operating Costs: Running a commercial bank in Nigeria is expensive. Banks spend large amounts of money on electricity, generators, fuel, salaries, staff training, security and technology. They must also maintain many branches and ATMs. These high costs reduce profit and sometimes force banks to charge customers higher fees for services. This makes banking more difficult for ordinary people.
• Weak Legal System: Debt recovery in Nigeria is slow because court processes take a long time. When a borrower refuses to repay a loan, the bank may take the matter to court. However, cases drag on for years before judgment is given. This weak legal system encourages some borrowers to avoid repayment since they know the bank cannot recover the money quickly. It reduces the willingness of banks to give out loans.
• Lack of Skilled Manpower: Although many people work in the banking sector, there is still a shortage of workers with advanced skills such as data analysis, risk management, cybersecurity and financial technology. Without skilled workers, banks may make poor decisions, lose money or fail to use modern banking tools effectively. This reduces the quality of banking services and slows innovation.
• Exchange Rate Instability: Nigeria’s exchange rate changes often. When the value of the naira falls sharply, banks face difficulties in foreign transactions. Importers and exporters become confused about prices and payment plans. Banks also find it hard to meet the foreign exchange needs of customers. Exchange rate instability reduces confidence in the banking system and makes international trade more challenging.

Final Thoughts

• Basic steps in credit creation- accepting deposits, keeping only a small part as cash reserve, and lending the rest to borrowers.
• Limitations to credit creation are cash reserves and legal requirements, low demand for loans, lack of collateral, Central bank controls, and public confidence and economic conditions.
• Problems of commercial banks in Nigeria include loan defaults, fraud and cybercrime, poor infrastructure and high operating costs, economic instability and weak legal systems, exchange rate fluctuations, and lack of skilled manpower

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Tags

Financial institutions, Commercial banks, Bank accounts, Current account, Savings account, Fixed deposit account, Deposits, Withdrawals, Interest, International trade, Foreign exchange, Letters of credit, Loans, Overdraft, Bills of exchange, Discounting, Credit creation, Cash reserve, Lending, Collateral, Central bank, Economic conditions, Credit facilities, Loan default, Fraud, Cybercrime, Infrastructure, Exchange rate, Economic growth