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commercial banks
Lecture 2

Dr. Ahmad Alsaraireh

What is a bank?

 Is a financial institution licensed to receive deposits,

make loans and may also provide financial services,
such as wealth management, currency exchange and
safe deposit boxes.
Role of banks

 It encourages savings habit amongst people and

thereby makes funds available for productive use.
 It acts as an intermediary between people having
surplus money and those requiring money for various
business activities.
 It facilitates business transactions through receipts and
payments by cheques instead of currency.
 It provides loans and advances to businessmen for short
term and long-term purposes.
Role of banks

 It also facilitates import export transactions.

 It helps in national development by providing credit to
farmers, small-scale industries and self-employed people
as well as to large business houses which lead to
balanced economic development in the country.
 It helps in raising the standard of living of people in
general by providing loans for purchase of consumer
durable goods, houses, automobiles, etc
Types of banks

 Retail banks are banks that offer checking and savings accounts, which
focuses on consumers (or the general public) as customers. These banks
give you credit cards, offer loans, and they’re the ones with numerous
branch locations in populated areas.
 Commercial banks focus on business customers. Businesses need checking
and savings accounts just like individuals do. But they also need more
complex services, and the dollar amounts (or the number of transactions)
can be much larger. They might need to accept payments from customers,
rely heavily on lines of credit to manage cash flow, and they might
use letters of credit to do business overseas.
Types of banks

 Investment banks help businesses work in financial

markets. If a business wants to go public or sell debt to
investors, they’ll often use an investment bank.
 Central banks manage the monetary system for a
government. For example, the Federal Reserve Bank is
the US central bank responsible for managing economic
activity and supervising banks.
Commercial Banks

Definition:
 Is a type of financial institution that accepts deposits;
offers checking account services; makes business,
personal and mortgage loans; and offers basic financial
products like CDs and savings accounts to individuals
and small businesses.
Functions of commercial banks

 The functions of commercial banks are broadly classified into primary

functions and secondary functions,
 Primary Functions:
1. Accepting Deposits: Implies that commercial banks are mainly dependent
on public deposits.
2. Advancing Loans: The public deposits are used by commercial banks for the
purpose of granting loans to individuals and businesses.
Functions of commercial banks

 Secondary Functions:
1. Agency Functions: Implies that commercial banks act as agents of
customers by performing various functions, which are as follows:
a. Collecting Checks: The banks collect checks and bills of
exchange on the behalf of their customers through clearing house
facilities provided by the central bank.
b. Collecting Income: Commercial banks collect dividends,
pension, salaries, rents, and interests on investments on behalf of their
customers.
c. Paying Expenses: Commercial banks make the payments of
various obligations of customers, such as telephone bills, insurance
premium.
 Functions of commercial banks

2. General Utility Functions:

Include the following functions:
a. Providing Locker Facilities: locker facilities are provided to customers for safe keeping
of valuable items. This minimizes the risk of loss.
b. Issuing Traveller's Checks: traveller's checks are issued to individuals for traveling
outside the country. Traveller's checks are the safe and easy way to protect money while
traveling.
c. Dealing in Foreign Exchange: commercial banks help in providing foreign exchange to
businessmen dealing in exports and imports. However, commercial banks need to take the
permission of the central bank for dealing in foreign exchange.
d. Transferring Funds: Refers to transferring of funds from one bank to another.
Functions of commercial banks

 3. Other Functions:
a. Creating Money: Refers to one of the important functions of commercial
banks that help in increasing money supply.
b. Electronic Banking: Include services, such as debit cards, credit cards, and
Internet banking.
Money creation

 Where does money come from? And How does it increase or decrease in
quantity?
 Answer : money is created by banks when they issue loans.

Before, starting with money creation, its better to understand the banks
finance.

Banks accept deposits and extend loans. However, these banks can’t lend all
deposits they have as they must keep a fraction of it as cash in their vaults or in
deposits in the Central bank, called Legal Reserve Ratio (LRR).
Money creation

 Through the process of money creation, commercial

banks are able to create credit, which is in far excess of
the initial deposits.
 This process can be better understood by making two
assumptions:
1. The entire commercial banking system is one unit and is
termed as ‘Banks’.
2. All receipts and payments in the economy are routed
through the Banks.
 Money creation

 The process of Money Creation through an example:

Suppose, initial deposits in banks is $1,000 and LRR is 20%. It means,

banks are required to keep only $200 as cash reserve and are
free to lend $800. Suppose they lend $800. Banks do not lend this
money by giving amount in cash. Rather, they open the accounts
in the names of borrowers, who are free to withdraw the amount
whenever the like.
 Suppose borrowers withdraw the entire amount of $800
for making payments. As all the transactions are routed
through the banks, the money spent by the borrowers
comes back into another bank in the form of deposit
accounts of those who have received this payment. It
will increase the demand deposits of that bank by $800.

 With new deposits of $800, the second bank keeps 20%

as cash reserves and lend the balance $640. Borrowers
use these loans for making payments, which again
comes back into the accounts of those who have
received the payments. This time, banks deposits rise by
$640.
 The deposits keep on increasing in each round by 80% of
the last round deposits. At the same time, cash reserves
also go on increasing, each time by 80% of the last cash
reserve. Deposit creation comes to end when total cash
reserves become equal to the initial deposit.

 banks are able to create total deposits of $5,000 with

the initial deposit of just $1,000. It means, total deposits
become ‘five times’ of the initial deposit.

 This “Five times” term is nothing but the value of ‘Money

Multiplier’.
Money Multiplier:

 Money Multiplier = 1/LRR

In the given example, LRR is 20% or 0.2. So,
Money Multiplier = 1/0.2 = 5
 It signifies that for every unit of money kept as reserves, banks are able to
create 5 units of money. Thus, if we want to know how much money the
initial deposit makes, all what wee need to do is to multiply the initial
deposit by the money multiplier.
 The value of money multiplier is determined by LRR. Higher the value of LRR,
lower is the value of money multiplier and less money is created by the
banking system.
 Determinants of money multiplier

 Reserve requirements decided by the central bank matters for

reserve -to -deposits ratio

 Willingness of banks to hold excess reserves for reserve-to-

deposits ratio

 Willingness of households and firms to hold cash instead of

deposits (liquidity risks) matters for currency-to-deposits ratio.
Money creation and money supply

 The creation of money will definitely increase the money supply, which in
turn leads to inflation. Therefore, governments try to control the process of
money creation through adjusting the reserve requirements.
 The relationship between money creation and reserve requirement is
negative. Which means if reserve ratio increases, the ability of banks to lend
decreases and vice versa.