3.2. Commercial Banks

• Accepting Deposits: Commercial banks accept various types of deposits, such as savings accounts, current accounts, and fixed deposits. • Providing Loans: Banks lend money to individuals, businesses, and the government, which is a key factor in the money creation process. • Credit Creation: Banks create credit by lending a portion of their deposits, which contributes to the overall money supply in the economy. • Other Services: Banks provide services like remittance, foreign exchange, investment advice, and insurance.

Commercial banks perform several vital functions in the economy. First, they accept deposits from customers in various forms, such as savings accounts, current accounts, and fixed deposits. This means that individuals and businesses can safely store their money in a bank. Second, they provide loans to those in need, including individuals wanting to buy a house or businesses looking to expand. This lending is crucial because it represents a major way they contribute to money creation—when banks lend money, they essentially generate new money through the credit they create. Additionally, banks offer a range of other services, which include helping customers with money transfers (remittance), exchanging currencies (foreign exchange), providing advice on investments, and offering insurance products. All these functions play a significant role in the smooth operation of the economy.

Think of a commercial bank like a community toolbox. Just as a toolbox holds various tools that people can borrow to build or repair things, a bank holds money that people can deposit and borrow when needed. If you wanted to build a birdhouse (like buying a home), you would need tools (loans) from the toolbox (bank) to get materials. Likewise, the bank uses the deposits it receives (tools) to lend out to others, thereby helping the entire community to grow and build their dreams.

Credit creation is a key function of commercial banks. When a bank receives deposits, it doesn’t keep all of that money in its vaults; instead, it lends a portion of it. The money lent out is then deposited back into the banking system, leading to the creation of new money. The Process of Credit Creation:

1. Initial Deposit: A customer deposits money in a bank.
2. Reserve Requirement: The bank is required to keep a certain percentage of the deposit as a reserve (this is known as the reserve ratio).
3. Lending the Excess Reserve: The remaining portion of the deposit is loaned out to borrowers, who then spend it. The borrowers' payments are deposited into other banks, starting the process again. The extent of credit creation depends on the reserve requirement set by the central bank. A lower reserve ratio means more money can be created, and a higher ratio limits credit expansion.

Credit creation is fundamental to how commercial banks operate and influence the economy. When someone deposits money in a bank, the bank doesn't just sit on that money; it is required to keep only a fraction of it as reserves for withdrawals (this is the reserve requirement). The bank can then lend out the rest, which individuals or businesses use for various purposes, like purchasing goods or investing in services. When these borrowers spend the money, that money often ends up being deposited into other banks, where it can once again be lent out. This cycle repeats, leading to more money being available than what was originally deposited. Central banks enforce rules on how much must be kept in reserve; if the ratio is lower, banks can lend more, creating more money in the system, while a higher reserve ratio limits how much they can lend.

Imagine filling a large jug with water (the initial deposit). The jug represents the bank, and the water symbolizes money. If you pour out some of that water (lend money), you can then use it for other things, like watering plants or splashing in a pool (spending). If those plants or the pool then leak some water back (deposits into the banking system), that water can be collected again in a different jug (another bank) and poured back out again. This constant cycle of pouring out and collecting water (credit creation) allows for much more water (money) to be in circulation than just what was originally in the first jug!

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