What is the major function of commercial banks?, Microeconomics

They take deposits which mean borrow money and make loans which means lend money. The interest rate they pay on the deposits is less than the interest rate they charge on their loans. This difference covers their overhead costs and profits.

If banks on-lend all the amount of money they receive as deposits, they won’t be able to give any money back to the depositors who come for the withdrawal of money from their accounts. On the other hand, if banks on-lent nothing and kept all the amount of money they receive as deposits in the locked safe, then there will be no profit. There is therefore a trade-off between liquidity which means having cash at hand and profitability. Banks often resolve this trade-off by maintaining the cash reserves which are the small ratio of the total deposits. Therefore if deposits are Rs. 100, banks might make a decision to keep Rs. 10 of that money in the form of liquidity and lend the remaining Rupees 90 as loans to businesses. In this particular case the reserve ratio is 10% (which is 10/100). Sometimes this reserve ratio is forced as the central bank requirement that commercial banks must fulfil.



Posted Date: 7/19/2012 4:09:50 AM | Location : United States

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