Commercial banks | ICSE Class 10 Economics Notes

This note covers the meaning of a commercial bank, its main functions, the types of deposits it accepts, the types of loans and methods by which it advances credit, and how commercial banks create credit through primary and derivative deposits.

What is a commercial bank?

A commercial bank is a financial institution that accepts deposits from the public and lends out part of these funds to those who want to borrow.

Commercial banks act as intermediaries between individuals or firms with surplus funds and those who need funds: people with excess money keep it as deposits with the bank, while borrowers take loans for homes, crops or business.

Banks are a part of the money-creating system of an economy, along with the central bank, the Reserve Bank of India (RBI) in India.

Definition: Commercial bank. An institution that accepts deposits of money from the public, repayable on demand or after a fixed period, and uses these funds to give loans and advances to borrowers.

How does a bank earn from the "spread"?

The interest rate a bank pays to depositors is lower than the rate it charges borrowers. This difference between the two rates is called the spread, which is the profit the bank keeps.

Because banks do not expect every depositor to withdraw money at the same time, they can safely lend out a large part of what is deposited with them while keeping only a portion in reserve to meet day-to-day withdrawals. In India, banks these days hold only a small proportion, close to five per cent, of their deposits as cash for this purpose.

Why do people prefer banks to keeping cash at home?

People prefer to keep their surplus funds with a bank rather than at home for two reasons. First, it may be safer, because cash kept at home can be lost or stolen, while money in a bank account is protected and recorded. Second, deposits with a bank earn interest, so the depositor's money grows over time instead of lying idle.

Why do commercial banks matter for the economy?

From the point of view of the whole economy, commercial banks are important because they are the main channel through which the savings of households and firms are made available as loans to borrowers, so that funds that would otherwise sit unused can support production, trade and consumption elsewhere.

A commercial bank, such as the State Bank of India (SBI), also keeps part of its own funds as reserves with the Reserve Bank of India (RBI), the central bank, so that it always has backing for the deposits it holds.

In India, the Reserve Bank of India (RBI) supervises the functioning of all commercial banks: it checks that banks maintain the required cash balance out of the deposits they receive, and it periodically collects information from banks on how much they are lending, to whom and at what interest rate, so that credit flows not only to profit-making traders but also to small cultivators and small-scale industries.

What are the main functions of a commercial bank?

Commercial banks perform several functions, but the two most basic ones are accepting deposits and advancing loans.

Through these two activities, banks also perform a third, closely linked function: credit creation: the process by which the banking system expands the total amount of deposits (and hence money supply) far beyond the cash originally deposited with it.

1. Accepting deposits of various kinds from the public, who want a safe place to keep their savings and earn some interest.
2. Advancing loans to borrowers who need funds for consumption, trade, industry or agriculture, charging interest that is higher than what is paid to depositors.
3. Creating credit, that is, expanding deposits in the banking system through a repeated cycle of deposits and loans.
4. Providing a cheque facility, which makes transactions safer and easier than carrying cash.

How are deposits and loans linked to credit creation?

Of these, deposits and loans are the raw material and the main business of a bank; credit creation is the outcome of the bank using deposits to make loans, which in turn become fresh deposits elsewhere in the system.

The deposit function and the lending function are closely linked: a bank can only lend as much as it is confident of being able to repay to depositors on demand, so it must always balance how much it lends against how much it keeps back as reserves.

How does the cheque facility add to a bank's usefulness?

The cheque facility that goes with a demand deposit also makes a bank useful beyond simply storing money. A depositor can instruct the bank, through a cheque, to pay a given sum out of the account to another person, so that large payments can be made without the risk and inconvenience of handling cash, and the funds move safely from one bank account to another.

Taken together, these functions show why commercial banks are described as intermediaries: they stand between savers and borrowers, and in doing so they also add to the total stock of money available in the economy through the credit they create.

What are the types of deposits accepted by commercial banks?

Deposits are the money that the public places with a bank, and they form the bank's main source of funds.

Banks accept deposits and pay an amount as interest on them, keeping people's money safe while also letting them withdraw it as and when required.

A deposit that can be withdrawn on demand, such as money in a savings account or current account, is called a demand deposit.

A deposit that has a fixed period before it matures, such as a fixed deposit, is called a time deposit.

In the modern economy, cheques and debit cards drawn against demand deposits make transactions more convenient and safer, even when such deposits do not earn interest, because they remove the need to carry large amounts of cash.

How do commercial banks advance loans?

The second main function of a commercial bank is advancing loans. A bank does not keep all the money deposited with it idle; it retains only a portion to repay depositors on demand and loans out the rest to borrowers who need funds, since banks earn their income chiefly from the interest on such loans.

A bank must always balance its lending so that it keeps enough funds to repay any depositor who asks for money back.

What are the main methods of advancing loans?

Borrowers use such funds for working capital, for example to pay for raw materials or wages before income from sales comes in, or for long-term needs such as buying machinery or a house.

What do banks check before sanctioning a loan?

Banks typically ask for documents proving income or employment, and may ask for collateral, before sanctioning a loan.

Definition: Collateral. An asset the borrower owns, such as property, deposits or gold, pledged as security to the lender; if the loan is not repaid, the lender has the right to sell the asset to recover the money.

How do Indian borrowers reach commercial banks for different kinds of loans?

In India, a farmer such as Arun, with seven acres of land, is able to obtain a crop loan directly from a bank at a comparatively low rate of interest, because, unlike most other borrowers in Sonpur, he is able to meet the bank's collateral and documentation requirements, and he may later apply for a fresh loan against a cold storage receipt once he has stored part of his harvest. Alongside banks, many rural borrowers in India also reach credit through cooperative societies: members pool their own deposits, and the cooperative uses these deposits as collateral to obtain a loan from a commercial bank, which it then re-lends to members for cultivation, agricultural trade, housing and other needs. Compared with borrowing from a moneylender, loans from a bank or a cooperative in India usually carry a much lower rate of interest, though they require documents and collateral that not every borrower can provide.

What is credit creation by commercial banks?

Credit creation is the process by which the total deposits in the banking system become much larger than the original cash deposited, because a bank does not keep the whole of a deposit idle; it lends out a large part of it, and this loan amount usually comes back into the banking system as a fresh deposit, which can again be partly lent out, and so on.

What does the story of Lala the goldsmith show?

The idea can be understood through the classic story of a goldsmith named Lala, who kept people's gold safely and issued paper receipts for it.

Because people did not come to withdraw all their gold at the same time, Lala found he could lend out some of the gold already held as deposits and issue fresh receipts for it, so that the total paper receipts in circulation grew larger than the gold he actually held.

How does the same cycle work in a modern bank?

The modern banking system works in exactly this way: banks lend because they do not expect all depositors to withdraw their funds at the same time, and when a bank lends to a person, a new deposit is effectively opened, so money supply rises by old deposits plus the new deposit.

In practice, when a borrower takes a loan and spends it, say by paying a supplier, that supplier usually deposits the money back into a bank account rather than holding it all as cash. This returning amount becomes a fresh deposit, and the bank holding it again keeps back only a small fraction as reserves before lending out the rest. Round after round, this cycle of lending, spending and redepositing allows the banking system as a whole to support a far larger total of deposits than the single original sum of cash that started the process. Credit creation is thus not something any one bank does in isolation; it is a property of the whole banking system acting together.

How do primary and derivative deposits explain credit creation?

To understand credit creation clearly, deposits are divided into two kinds. A primary deposit is the original cash a depositor places with a bank.

A derivative deposit is a deposit that arises later, not from fresh cash, but because the bank has lent out part of an earlier deposit and the borrowed amount comes back into the banking system as a new deposit.

Definition: Primary deposit and derivative deposit. A primary deposit is cash deposited directly by the public. A derivative deposit is created when a bank lends part of its deposits and the loan amount re-enters the banking system as a fresh deposit.

What is the Cash Reserve Ratio (CRR)?

Banks are not allowed to lend out the whole of every deposit. The Reserve Bank of India (RBI), the central bank, fixes a minimum percentage of deposits that every bank must keep as cash reserves; this is called the Cash Reserve Ratio (CRR).

Only the remaining amount can be lent. This requirement limits how much credit, and therefore how many derivative deposits, the banking system can ultimately create.

Definition: Cash Reserve Ratio. The percentage of its total deposits that a bank is legally required to keep as reserves, mainly in cash or with the central bank, rather than lend out.

How does the cycle of lending and redepositing play out?

Suppose a bank receives a primary deposit of ₹100 and the CRR is 20 per cent. It must keep ₹20 as reserves and can lend out ₹80.

If this ₹80 is borrowed and spent, it is likely to come back into the banking system as a new (derivative deposit).

The bank receiving this ₹80 deposit again keeps 20 per cent as reserves and lends the rest, and the cycle repeats. The process continues, round after round, until the total reserves held across the system equal the original cash deposit.

At that point, total deposits in the system reach a maximum, well above the original primary deposit.

Total deposits = Primary deposit ÷ CRR gives the maximum deposits the system can support for a given reserve requirement, because reserves must equal CRR multiplied by total deposits.

Worked example. A commercial bank receives a primary deposit of ₹100 in cash. The Cash Reserve Ratio fixed by the central bank is 20 per cent. Find the maximum total deposits (primary plus derivative) that the banking system can create from this primary deposit.

Answer: Reserves must equal 20 per cent of total deposits. Since the bank starts with ₹100 in reserves, total deposits = Reserves ÷ CRR = 100 ÷ 0.20 = ₹500.

Of this, ₹100 is the original primary deposit and the remaining ₹400 is made up of derivative deposits created as successive rounds of lending return to the banking system as fresh deposits.

The bank's total loans in this process come to ₹400 (500 minus the ₹100 reserve kept back).

How does a change in CRR affect credit creation?

A lower Cash Reserve Ratio allows a larger volume of credit creation, because more of each deposit can be lent out and returned as a new deposit, while a higher CRR restricts the amount of credit the banking system can create from the same primary deposit.

Going beyond the syllabus

The multiplying effect shown above is sometimes summarised through a money multiplier: the ratio by which an initial deposit of cash reserves can expand into total deposits; it is calculated as the reciprocal of the Cash Reserve Ratio.

Students may also come across the idea that the central bank acts as the "lender of last resort" to commercial banks, stepping in with funds when the banking system itself falls short, and that it uses tools such as the bank rate and open market operations to influence how much credit banks are able to create across the whole economy.

Alongside commercial banks and cooperative societies, many rural borrowers also obtain credit from informal sources such as moneylenders, traders, employers, or relatives and friends. Loans from banks and cooperatives are usually called formal sector credit, while loans from moneylenders, traders and others are called informal sector credit; informal lenders generally charge much higher interest and are not supervised by any authority, which makes such credit more costly and riskier for the borrower.

A borrower deciding where to take a loan from typically compares not just the interest rate but also the collateral and documentation demanded, and the ease and flexibility of repayment, because easy terms of credit usually mean a low interest rate, easy repayment conditions, and less collateral and documentation required.

These wider ideas are useful background, but the syllabus itself asks only for the meaning of a commercial bank, its functions of accepting deposits and advancing loans, and credit creation through primary and derivative deposits, as covered in the sections above.

Glossary

• Commercial bank — an institution that accepts deposits from the public and lends out part of these funds to borrowers.
• Demand deposit — a deposit that the depositor can withdraw from the bank at any time without notice.
• Time deposit — a deposit kept with the bank for a fixed period before it matures.
• Fixed deposit — a lump sum deposited for an agreed period at a higher rate of interest.
• Recurring deposit — a fixed sum deposited regularly over an agreed period, with interest paid at maturity.
• Cash credit — a loan arrangement where the borrower can draw funds up to a sanctioned limit as needed.
• Overdraft — permission to withdraw more than the balance in a current account, up to a set limit.
• Discounting of bills — a bank buying a bill of exchange before maturity at less than its face value.
• Collateral — an asset pledged by a borrower as security against a loan.
• Credit creation — the process by which total bank deposits grow larger than the cash originally deposited, through repeated lending.
• Primary deposit — cash deposited directly with a bank by a member of the public.
• Derivative deposit — a deposit created when a loan made by a bank returns to the banking system as a fresh deposit.
• Cash Reserve Ratio — the minimum percentage of deposits a bank must keep as reserves rather than lend out.
• Spread — the difference between the interest rate charged to borrowers and the lower rate paid to depositors.
• Money multiplier — the ratio, equal to one divided by the reserve ratio, showing how much total deposits can expand from an initial reserve.

Common errors and misconceptions

• Misconception: A bank can lend out the whole of any deposit it receives. Correct: A bank must keep a fixed percentage of deposits as reserves (the Cash Reserve Ratio) and can lend only the remainder.
• Misconception: A current account and a savings account are the same thing. Correct: Current deposits are mainly for frequent business transactions with unlimited withdrawals and usually no interest, while savings deposits earn interest but allow only limited withdrawals.
• Misconception: Credit creation means a bank is printing new currency. Correct: Credit creation only expands bank deposits through lending and re-depositing; it does not involve issuing new currency notes, which only the central bank can do.
• Misconception: A derivative deposit is a type of fixed deposit. Correct: A derivative deposit is any deposit that arises indirectly because an earlier loan has returned to the banking system, not a product named "derivative deposit" offered to customers.
• Misconception: Overdraft and cash credit are identical. Correct: An overdraft is linked to a current account and is usually short-term, while cash credit is a separate credit limit sanctioned against security for working capital needs.
• Misconception: Banks earn their profit mainly from fees. Correct: A bank's main source of profit is the "spread", the gap between the higher interest it charges on loans and the lower interest it pays on deposits.
• Misconception: A higher Cash Reserve Ratio allows banks to create more credit. Correct: A higher CRR means banks must keep more funds idle as reserves, which reduces, not increases, the amount of credit the banking system can create.

Exam-style questions with model answers

Q1. State what is meant by a demand deposit. [2 marks]

1. A demand deposit is a deposit that the account holder can withdraw at any time without giving prior notice to the bank.
2. Savings and current account balances are common examples of demand deposits.

Q2. Distinguish between a fixed deposit and a recurring deposit. [3 marks]

1. A fixed deposit is a lump sum deposited once for a fixed period, while a recurring deposit involves depositing a fixed smaller sum at regular intervals, usually monthly.
2. Both earn interest, but in a fixed deposit interest accrues on the whole lump sum from the start, while in a recurring deposit interest builds up gradually as each instalment is added.
3. Withdrawal before maturity is generally restricted in both, but a recurring deposit is better suited to savers who cannot set aside a large sum at once.

Q3. Explain, with one example each, the difference between cash credit and an overdraft. [4 marks]

1. Cash credit is a separate loan account where the bank sanctions a credit limit, often against the security of stock or goods, and the borrower draws funds as required, paying interest only on the amount used; for example, a trader may be sanctioned cash credit to buy stock for the festival season.
2. An overdraft is an arrangement linked to a current account where the holder is permitted to withdraw more than the account balance up to an agreed limit, usually for a short period, for example to cover a temporary shortfall in funds.
3. Cash credit is typically used for ongoing working capital needs of a business, whereas an overdraft is used for short, occasional shortfalls.
4. Interest in cash credit is calculated on the amount actually drawn against the sanctioned limit, and similarly in an overdraft interest applies only to the amount overdrawn, not to the whole sanctioned limit.

Q4. What is meant by the "spread" earned by a commercial bank? [2 marks]

1. The spread is the difference between the rate of interest a bank charges borrowers on loans and the lower rate of interest it pays depositors.
2. This difference is the main source of profit for the commercial bank.

Q5. Explain the meaning of primary and derivative deposits and show how they together make up credit creation. [5 marks]

1. A primary deposit is the original cash a person deposits with a bank.
2. A bank keeps only a fraction of this deposit as cash reserves, as required by the Cash Reserve Ratio, and lends out the rest.
3. When this loan amount is spent and received by another person, it is usually redeposited in the banking system, creating a derivative deposit, which did not exist as fresh cash but arose from lending.
4. The bank receiving this derivative deposit again keeps a fraction as reserves and lends the remainder, so the cycle of lending and redepositing repeats.
5. The sum of the original primary deposit and all the successive derivative deposits created through this cycle is what is meant by credit creation, and it continues until the total reserves held equal the amount of the original primary deposit.

Q6. A commercial bank receives a primary deposit of ₹200 in cash, and the Cash Reserve Ratio fixed by the central bank is 25 per cent. Calculate the maximum total deposits the banking system can create, and state the total amount of loans made in the process. [6 marks]

1. The Cash Reserve Ratio requires reserves to equal 25 per cent of total deposits.
2. Since the bank starts with ₹200 as reserves, total deposits = Reserves ÷ CRR = 200 ÷ 0.25 = ₹800.
3. Of this ₹800, the original primary deposit is ₹200.
4. The remaining ₹600 of total deposits represents derivative deposits created through successive rounds of lending that return to the banking system as fresh deposits.
5. Total loans made by the bank equal total deposits minus the reserves kept, that is, ₹800 minus ₹200, which comes to ₹600.
6. This shows that a higher CRR of 25 per cent, compared with a CRR of 20 per cent, gives a smaller money multiplier and so allows less credit creation for a given primary deposit.

Q7. State three documents or conditions a bank typically requires before sanctioning a loan, and explain briefly why each is needed. [3 marks]

1. Proof of the borrower's employment and income, which the bank studies carefully to judge whether the borrower has a steady enough income to repay the loan along with interest on time.
2. Collateral, such as property, deposits with the bank, or other valuable assets, which the bank can sell to recover its money if the borrower is unable to repay the loan.
3. A signed loan agreement specifying the interest rate, the repayment schedule and the exact purpose of the loan, which protects both the bank and the borrower by setting out the agreed terms of credit clearly in writing.

Q8. Why do commercial banks ask for collateral before advancing a loan? [2 marks]

1. Collateral is an asset the borrower owns that is pledged as security against the loan.
2. If the borrower fails to repay, the bank can sell this asset to recover the money owed, which reduces the bank's risk of loss.

Key takeaways

• A commercial bank accepts deposits from the public and lends out part of these funds to borrowers, earning profit from the spread between lending and deposit interest rates.
• Deposits accepted by banks include fixed, savings, current and recurring deposits, each with different rules on interest and withdrawal.
• Banks advance loans through several methods, including straightforward loans, cash credit, overdrafts and the discounting of bills of exchange.
• Banks usually ask for documents and collateral before sanctioning a loan, to be confident of repayment.
• Credit creation is the process by which total bank deposits expand well beyond the cash originally deposited, because banks lend out most of each deposit they receive.
• A primary deposit is original cash deposited by the public; a derivative deposit arises when a loan returns to the banking system as a fresh deposit.
• The Cash Reserve Ratio limits how much a bank can lend and therefore how much credit the banking system can create from a given primary deposit.
• Total deposits that can be created from a primary deposit are found by dividing the primary deposit by the Cash Reserve Ratio.

Test yourself

What is the main function performed by a commercial bank between depositors and borrowers?

A commercial bank mediates between those with surplus funds (depositors) and those needing funds (borrowers), accepting deposits and lending part of them out at a higher interest rate.

Name two types of deposits that pay interest and allow only limited withdrawals.

Fixed deposits and savings deposits are examples of deposits that pay interest while restricting the number or timing of withdrawals.

What is meant by "discounting of bills of exchange"?

It is a method of advancing credit where a bank buys a bill of exchange from a trader before its maturity date, paying less than its face value, giving the trader immediate funds.

Why does a bank ask for collateral before giving a loan?

Collateral is an asset pledged by the borrower as security; if the loan is not repaid, the bank can sell this asset to recover its money, reducing its risk.

What is a derivative deposit?

A derivative deposit is a deposit created not from fresh cash but because a loan made by a bank has returned to the banking system as a new deposit.

If the Cash Reserve Ratio is lower, what happens to the amount of credit a bank can create from a given primary deposit?

A lower Cash Reserve Ratio means a smaller fraction of each deposit must be kept as reserves, so more can be lent out, allowing a larger total amount of credit to be created.

What is the "spread" in banking?

The spread is the difference between the higher interest rate a bank charges on loans and the lower interest rate it pays on deposits, which forms the bank's main source of profit.