Functions of commercial bank - granting a loan, Macroeconomics

Granting a loan: When commercial banks lend, they create money. This can be explained by extending the hypothetical example of Bank A.

Suppose company XYZ Ltd. approaches Bank A and requests for a loan of Rs.5,75,000 which is just equal to the excess reserves including cash with the bank (i.e. 4,72,500 + 1,02,500). If the loan is granted, the company hands over a promissory note. Thus, the company's demand deposits in the bank rises by Rs.5,75,000 and the bank possesses a new asset - a promissory note - which it includes under the head 'Loans'. Increase in demand deposits should accompany by an increase in its holdings of liquid assets to Rs.2,80,000 which will be adjusted through excess reserves. The balance sheet of Bank A, when the loan is granted appears as given below.

Balance Sheet of Bank A

Liabilities                           Rs.                Assets                             Rs.

Capital

Demand deposits

5,00,000

7,25,000

Cash

Reserves with RBI

Required liquid assets
Loans

1,02,500

2,93,750

2,53,750
5,75,000

A closer look at the balance sheet reveals an important fact - when a bank makes a loan, it creates money. The company has got something - a demand deposit which is money, in return for something - a promissory note which is not money. Thus, by extending credit Bank A has monetized a promissory note.

The ability of commercial banks to create money by lending is highly dependent on the reserves it has apart from the reserves it has to have with the RBI.

Suppose, in the above example, if company XYZ Ltd. draws a cheque of Rs.5,75,000 and gives it to another company ABC Ltd. which deposits it in Bank C. Bank C can now claim the amount of the cheque  from Bank A. However, the reserves of Bank A with the Reserve Bank are only Rs.2,93,750 whereas the cheque amount exceeds it. Bank A will cover the difference by depositing the idle reserves with it i.e. cash of Rs.1,02,500 and liquid assets of Rs.2,01,250. Now, the reserves of Bank A with RBI will be Rs.5,97,500 which would be enough to meet the claims of Bank C on Bank A.

Thus, when the cheque is presented for collection by Bank C, the RBI will reduce the reserves of Bank A with it by Rs.5,75,000 and the demand deposits of Bank A will also be reduced by the same amount. The balance sheet after the clearance of cheque of Rs.5,75,000 will appear as follows:

     Clearance of cheque means reduction of demand deposits and in turn reduction of required holdings of liquid assets (i.e. demand deposits would reduce to Rs.1,50,000 and excess required liquid assets would be Rs.2,01,250).

 

Balance Sheet of Bank A

Liabilities                         Rs.                   Assets                           Rs.

Capital

5,00,000

Cash

-

Demand deposits

1,50,000

Reserves with RBI

22,500

 

 

Required liquid assets

52,500

 

 

Loans

5,75,000

After the cheque has been collected, it is clear from the balance sheet, the Bank A is barely meeting its need of total reserves of 50 percent - 15% of cash reserve requirement and 35% of statutory liquid requirement. But, if the amount of the cheque was greater than Rs.5,75,000, Bank A could not have met the total reserve requirement. Thus, a single commercial bank in a multi-bank banking system can lend only an amount equal to its pre-loan excess reserves.

Posted Date: 9/18/2012 6:21:56 AM | Location : United States







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