Role and importance of commercial banks

Published by Patrick Mutisya · 14 days ago

Cambridge IGCSE Economics 0455 – Role and Importance of Commercial Banks

Microeconomic Decision‑Makers: Money and Banking

Objective

Explain the role and importance of commercial banks in a market‑based economy.

What is a Commercial Bank?

A commercial bank is a 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 for profit and is regulated by the central bank.

Key Functions of Commercial Banks

FunctionExplanationEconomic Impact
Accepting DepositsSafekeeping 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.
Providing LoansExtends credit to individuals (personal loans, mortgages) and businesses (working‑capital loans, investment finance).Mobilises saved funds for productive use, stimulating investment and consumption.
Payment ServicesIssues cheques, debit cards, electronic funds transfers and online banking.Facilitates the smooth exchange of goods and services, reducing transaction costs.
Foreign Exchange ServicesBuys and sells foreign currencies for customers and businesses.Supports international trade and travel, helping the economy to engage with global markets.
Safeguarding \cdot aluablesProvides safe‑deposit lockers for jewellery, documents and other valuables.Enhances public trust in the banking system.

Why Commercial Banks Are Important

  • Intermediation of Funds: They channel savings from households to firms that need capital, promoting efficient allocation of resources.

  • Money Creation: Through the process of fractional‑reserve banking, banks can create new money when they grant loans. If the reserve ratio is r, the maximum potential increase in the money supply is given by:

    \$\Delta M = \frac{1}{r} \times \text{Initial Deposit}\$

  • Economic Stability: By providing credit, banks help smooth out fluctuations in income and consumption, supporting steady economic growth.

  • Facilitation of Trade: Payment and foreign‑exchange services enable both domestic and international transactions.

  • Employment: The banking sector creates jobs directly (bank staff) and indirectly (support services, technology providers).

How Commercial Banks Create Money

  1. A customer deposits $1,000 in a checking account.

  2. The bank keeps a fraction as reserves (e.g., 10% = \$100) and can lend out the remaining \$900.

  3. The borrower spends the $900, and the recipient deposits it in another bank.

  4. The second bank repeats the process, keeping 10% (\$90) and lending \$810, and so on.

This chain of deposits and loans expands the total money supply beyond the original deposit.

Regulation and Supervision

Commercial banks are supervised by the central bank (e.g., the Bank of England, Federal Reserve) to ensure:

  • Solvency – banks maintain adequate capital.

  • Liquidity – banks can meet withdrawal demands.

  • Compliance with prudential standards such as reserve requirements and loan‑to‑value ratios.

Potential Risks

  • Bank Runs: If many depositors withdraw simultaneously, a bank may run out of cash.

  • Bad Loans: Poor credit assessment can lead to defaults, threatening bank stability.

  • Systemic Risk: Failure of a large commercial bank can affect the whole financial system.

Summary

Commercial banks play a central role in modern economies by mobilising savings, providing credit, facilitating payments, and contributing to money creation. Their proper regulation is essential to maintain confidence, protect depositors and support sustainable economic growth.

Suggested diagram: Flow of funds from households to firms via commercial banks, showing deposits, loans, and money creation.