Role and importance of commercial banks

Micro‑economic Decision‑Makers: Money and Banking

Objective

Explain the role and importance of commercial banks in a market‑based economy and describe how money, the banking system and money creation are linked.

1. Money – Forms, Functions and Characteristics

1.1 Definition

Money is any item that is widely accepted as a means of payment for goods and services and for the repayment of debts.

1.2 Functions of Money

• Medium of exchange – used to buy and sell goods and services.
• Unit of account – provides a common measure for valuing goods, services and debts.
• Store of value – can be saved and retrieved in the future without losing much of its value.
• Standard of deferred payment – allows transactions to be settled at a later date (e.g., loans, credit).

1.3 Characteristics of Good Money

Characteristic	Why it matters
Durability	Does not wear out quickly (e.g., metal coins, polymer notes).
Portability	Easy to carry and transfer.
Divisibility	Can be broken into smaller units for transactions of any size.
Uniformity (Standardisation)	All units of the same denomination are identical.
Acceptability	Widely accepted by people, businesses and the state.
Stability	Retains its purchasing power over time.

1.4 Forms of Money

Form	Examples	Notes
Legal‑tender cash	Coins (metal), banknotes (paper or polymer)	Issued by the central bank; accepted for all debts.
Demand deposits	Current (checking) accounts, savings accounts	Electronic money that can be withdrawn on demand; used in cheque and card payments.
Electronic money	Debit cards, credit cards, mobile‑payment apps, online wallets	Facilitates non‑cash transactions; linked to demand deposits.
Representative money	Gold certificates, banknotes convertible into a commodity	Value is backed by a physical commodity (historical).
Fiat money	Modern banknotes and coins, digital balances	Has value because the government declares it legal tender; not backed by a commodity.

2. The Banking System

2.1 Central Bank – Role and Importance

• Issue of legal tender – sole authority to create and supply banknotes and coins.
• Monetary policy – sets policy rates (e.g., base rate, repo rate) that influence commercial‑bank lending rates and the overall money supply.
• Lender of last resort – provides emergency liquidity to banks facing temporary cash shortages.
• Regulation and supervision – monitors banks to ensure solvency, liquidity and compliance with prudential standards.
• Management of foreign reserves – intervenes in foreign‑exchange markets to stabilise the national currency.
• Financial‑system stability – oversees systemic risk and may act as a “banker’s bank”.

2.2 Commercial Bank – Definition

A commercial bank is a profit‑making financial institution that accepts deposits from the public and provides a range of services such as granting loans, facilitating payments and offering other financial products. It operates under the supervision of the central bank.

3. Role and Importance of Commercial Banks

Function	Explanation	Economic Impact
Accepting deposits	Safekeeping of money in current, savings and fixed‑deposit accounts.	Provides households and firms with a secure place to store money, increasing confidence in the financial system.
Granting loans	Provides credit to individuals (personal loans, mortgages) and businesses (working‑capital, investment finance).	Mobilises saved funds for productive use, stimulating investment, consumption and economic growth.
Payment services	Issues cheques, debit/credit cards, electronic funds transfers, online‑banking and mobile‑payment platforms.	Reduces transaction costs and enables smooth exchange of goods and services.
Foreign‑exchange services	Buys and sells foreign currencies for customers and businesses; provides forward contracts and letters of credit.	Supports international trade, travel and foreign investment.
Safeguarding valuables	Offers safe‑deposit lockers for jewellery, important documents and other valuables.	Enhances public trust in the banking system.
Agency and investment services	Acts as trustee, nominee, or broker; sells government bonds, mutual funds and insurance products.	Broadens access to financial markets and diversifies household income sources.

Key Reasons Why Commercial Banks Are Important

• Intermediation of funds: Channel savings from households to firms that need capital, promoting an efficient allocation of resources.
• Money creation: Through fractional‑reserve banking, banks create new money when they grant loans.
• Economic stability: Credit smooths fluctuations in income and consumption, supporting steady growth.
• Facilitation of trade: Payment and FX services enable domestic and international transactions.
• Employment: The banking sector creates jobs directly (bank staff) and indirectly (technology providers, support services).
• Financial inclusion: Provides banking services to previously unbanked individuals and small enterprises.

4. Money Creation – Fractional‑Reserve Banking

4.1 The Money Multiplier

If the reserve ratio is r, the money multiplier (MM) is:

\[ \text{MM} = \frac{1}{r} \]

The maximum potential increase in the money supply (\(\Delta M\)) from an initial deposit (\(D\)) is:

\[ \Delta M = \text{MM} \times D = \frac{1}{r} \times D \]

4.2 Step‑by‑Step Example (Reserve ratio = 10 %)

1. Customer deposits $1,000 in Bank A.
2. Bank A keeps 10 % as reserves ($100) and can lend $900.
3. Borrower spends the $900; the recipient deposits it in Bank B.
4. Bank B retains 10 % ($90) and lends $810.
5. The process repeats, creating a series of deposits and loans.

The total amount of money that could be created approaches:

\[ \Delta M = \frac{1}{0.10} \times 1{,}000 = 10{,}000 \]

In practice the actual increase is lower because banks hold excess reserves, some cash is withdrawn and loan demand may be limited.

4.3 Diagram (Suggested for Exam)

• Money‑multiplier flow‑chart showing: Initial deposit → Reserves → Loans → New deposits → Repeat.
• Label the reserve ratio, the multiplier and the final money‑supply expansion.

5. Regulation and Supervision of Commercial Banks

Commercial banks are supervised by the central bank (or a dedicated banking regulator) to protect depositors and maintain financial stability.

• Reserve requirement – minimum proportion of deposits that must be kept as cash or central‑bank reserves.
• Capital adequacy ratio (CAR) – ratio of a bank’s capital to its risk‑weighted assets (e.g., Basel III minimum 8 %).
• Liquidity ratio – ensures banks can meet short‑term obligations (e.g., Liquidity Coverage Ratio).
• Loan‑to‑value (LTV) and debt‑service‑to‑income (DSTI) limits – control the amount of credit granted.
• Prudential reporting – regular submission of balance‑sheet data, stress‑test results and compliance checks.
• Deposit insurance – protects small depositors (e.g., up to a statutory limit) and helps prevent bank runs.

6. Potential Risks to Commercial Banks

• Bank runs – mass withdrawals can exhaust cash reserves; mitigated by reserve requirements and deposit insurance.
• Credit (bad‑loan) risk – borrowers may default, eroding profitability and capital.
• Liquidity risk – inability to meet short‑term obligations despite having adequate assets.
• Interest‑rate risk – mismatches between the rates on assets (loans) and liabilities (deposits) affect profit margins.
• Systemic risk – failure of a large bank can threaten the whole financial system, prompting central‑bank intervention.

7. Summary

Commercial banks are a cornerstone of a market‑based economy. They mobilise savings, provide credit, facilitate payments, support international trade and create money through fractional‑reserve banking. Effective regulation by the central bank safeguards depositors, maintains confidence and ensures that banks contribute to sustainable economic growth.

Suggested Diagrams for Examination

• Flow of funds diagram: Households → Commercial banks → Firms (deposits, loans, interest payments).
• Money‑multiplier diagram: Shows reserve ratio, multiplier and the step‑wise expansion of the money supply.
• Bank balance‑sheet snapshot: Illustrates assets (reserves, loans, securities) versus liabilities (deposits, capital).