Explain five factors that may limit credit creation in an economy. (10 marks)November 2022

Credit creation refers to the process by which banks and other financial institutions create new money by issuing loans and other forms of credit. However, there are several factors that may limit credit creation in an economy, these include:

1. Reserve requirements: Banks are typically required to hold a certain percentage of their deposits in reserve, which limits the amount of money they can lend out. The higher the reserve requirements, the less money banks can lend, and the more limited credit creation will be.
2. Capital adequacy ratios: Banks are also typically required to maintain a certain level of capital, which is a measure of their financial strength. The higher the capital adequacy ratios, the less money banks can lend, and the more limited credit creation will be.
3. Credit risk: Banks will only lend to borrowers who are considered to be creditworthy, which means that they have a good credit history and a steady income. If there are not enough creditworthy borrowers in the economy, credit creation will be limited.
4. Economic conditions: Economic conditions, such as recession or high unemployment, can also limit credit creation. When the economy is not doing well, there is less demand for loans, and banks may be less willing to lend.
5. Central bank’s monetary policy: Central banks can also limit credit creation by raising interest rates or selling government bonds, which can make it more expensive for banks to borrow money.
6. Legal and regulatory framework: Legal and regulatory frameworks such as Basel III, Dodd-Frank can affect the amount of money banks can lend by imposing more stringent regulations on the banking sector.
7. Risk appetite: Banks may also limit credit creation if they perceive a high level of risk in the economy, which can lead them to hold on to more capital and lend less.