Chapter 3 · Question 3
How do banks use deposits to provide credit?
Answer
Direct Answer
Banks accept deposits from people and keep only a small part as cash for withdrawals. The remaining deposits are used to give loans to borrowers. This links savers and borrowers and supports economic activity.
Simple Explanation
Banks keep a small fraction of deposits as cash for daily withdrawals and lend out the rest to borrowers, earning interest. This connects people who save with people who need funds.
Exam-Ready Structure
Banks play a crucial intermediary role in the economy by mobilising deposits and extending credit:
• Accepting deposits: People and businesses deposit their surplus money in bank accounts — savings accounts, current accounts, fixed deposits. In return, banks pay them interest.
• Cash reserve: Banks are required by the RBI to keep a certain percentage of deposits as a cash reserve (Cash Reserve Ratio). This ensures that depositors who want to withdraw money can do so without delay.
• Lending the remainder: The remaining deposits (after keeping the cash reserve) are used to give loans — agricultural loans to farmers, home loans, business loans, personal loans, etc. Banks charge interest on these loans, which is higher than the interest they pay depositors. The difference (spread) is the bank's income.
• Connecting savers and borrowers: Most people who have surplus funds are not the same as those who need funds. Banks solve this problem: they pool small deposits from many savers and make large sums available to borrowers.
• Credit creation: When a bank lends money, it does not hand over sacks of cash. It credits the borrower's account with a deposit. The borrower can then write cheques or make digital payments against that deposit. In this way, the total stock of money in the economy expands — the same original deposit supports multiple loans and transactions through the banking system. This is called 'credit creation' or 'money multiplier' effect.
• Economic importance: By channelling savings into productive loans, banks fund agriculture, industry, trade, and housing, making economic growth possible.
Key Points
- Banks accept deposits from people and keep only a small part as cash for withdrawals.
- The remaining deposits are used to give loans to borrowers.
- This links savers and borrowers and supports economic activity.