A commercial bank is that financial institution which accepts deposits from the people and offers loans for the purpose of consumption or investment.
The rate if interest charged by the commercial banks(for the loans the offer) is higher the the rate of interest paid by them (for the deposits the accept ).The difference between two rates is called ‘spread’, which is the source of profit for the banks.
BASIC FUNCTION OF COMMERCIAL BANKS
Commercial banks perform two basic function:
2. Advancing loans.
CREDIT CREATION PROCESS OF COMMERCIAL BANKS
Commercial banks create credit on the basics of their cash reserve .
Let assume all banks in the economy receive cash deposit of RS.10000. The banks are guided by their historical experience that all the depositors never withdraw their deposits at a single time. Thus, the bank find it safe to keep cash reserve of only 10% of their demand deposit. That is RS. 10000.
Now , the banks can safely advance loans of RS.9000 and earned profit. The banks never offer loan on cash so the loan amount again returned back to banking system of an economy. Now the total deposit of bank is RS.10000+RS.9000= RS.19000.
By keeping 10%of secondary deposit that is RS.9000 of 9000 he again lend RS.8100 and this process is going to continue until all cash balance are not going to exhaust.
With the help of credit multiplier a bank can know maximum of credit creation .
K = 1/RR
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