Commercial banks

Also called: Bank · Topic: Banking, Credit Creation and Monetary Policy · NCERT: Class 7, Ch 8 "Banks and the Magic of Finance"; Class 12, Ch 3 "Money and Banking"

Meaning

Commercial banks are financial institutions that accept deposits from the public and lend a part of that money to borrowers. When they give loans, they create new deposits, so they are part of the money-creating system.

They connect people who save with people who need money. By creating credit (new loans and deposits), they help fund businesses, farming and infrastructure.

Bank's earning (spread) = Interest rate charged on loans − Interest rate paid on deposits

Explanation

How a commercial bank works: financial intermediation

• Financial intermediation means the bank stands between savers and borrowers.
• Savers have extra money. Borrowers need money.

• The bank pools (collects together) many small deposits and lends most of them out as loans.

• NCERT example:

• Navdeep puts his spare money in a bank.
• Rima runs a bamboo business. Her friends and family cannot give her all the money she needs.

• The bank lends to Rima from its pool of deposits, which includes Navdeep's money.

• Why the middleman helps:

• The saver does not carry the risk. Navdeep does not have to judge whether Rima can repay. The bank does that.
• Search costs fall. Savers and borrowers do not have to find each other.
• Small sums become big loans. Many small deposits together can fund large projects.

How a bank earns: the spread (worked example, illustrative)

• The bank pays depositors 6% a year and charges borrowers 10% a year.
• It lends out ₹100 crore of deposits:
• It earns ₹10 crore as interest from borrowers.

• It pays ₹6 crore as interest to depositors.

• Spread = 10% − 6% = 4 percentage points, or ₹4 crore.

• The spread pays the bank's costs, and what is left is its profit.
• Spread falls when: deposit rates rise faster than loan rates, or competition forces banks to cut loan rates.
• Spread rises when: banks can charge borrowers more while paying depositors the same.

Banks as creators of credit

• Joseph Schumpeter said the banker is "not only a middleman".
• The banker is a "producer" of credit.

• Bank credit helps entrepreneurs "transform ideas into reality".

• Credit creation (banks creating new money by lending):

• The bank gives a loan → the loan amount is put into the borrower's account as a new deposit.
• That deposit can be spent and deposited again → the bank lends again.

• So the total money in the economy grows to more than the cash first deposited.

• This is why commercial banks are called part of the money-creating system. Only institutions that take deposits and also lend can do this.

Types of commercial banks in India

• Public sector banks, where the government is the majority owner
• Private sector banks, where private shareholders are the majority owners
• Foreign banks
• Regional Rural Banks (RRBs), which serve rural areas
• Small finance banks, which lend mainly to small businesses and low-income groups
• Payments banks, which take small deposits and handle payments but cannot give loans. So they cannot create credit the way other commercial banks do.

In India

• Regulator: the RBI (Reserve Bank of India, 1935) regulates banks, NBFCs (non-banking financial companies), payment systems and all-India financial institutions.
• Place in the financial sector: commercial banks sit alongside:
• investment banks, which help companies raise money by selling shares and bonds
• stock exchanges (regulated by SEBI)

• the foreign exchange market

• Growth of private banks:

• 1991: economic reforms opened banking to new private players.
• 1993: RBI guidelines licensed the first new private banks.

• 2016: on-tap licensing began. This means RBI accepts licence applications at any time, not only in rare rounds.

• On-tap guidelines: RBI issued the Guidelines for 'on tap' Licensing of Universal Banks in the Private Sector on 1 August 2016, after releasing a draft on 5 May 2016 for comments [2].

• A universal bank can offer the full range of services: deposits, loans and other financial services.

• The guidelines allow a NOFHC (Non-Operative Financial Holding Company) structure. This is a parent company that owns the bank but does not do banking itself [2].

• Foreign investment: up to 74% is allowed in private sector banks.

• Rural credit support: NABARD (1982) refinances banks that lend for farming, village industries and rural infrastructure.

• Refinance means NABARD gives money to these banks instead of lending to farmers directly. This lowers the banks' cost of lending.

• Ancient example: in early India, temples worked like banks.

• They lent to artisans, merchants and local governments.
• They did not take deposits from the public.
• A 13th-century Kodumbalur (Tamil Nadu) inscription records communities that borrowed from the Tirumudukunramudaiya-Nayanar temple and agreed to pay interest.

Don't confuse with

• Payments banks: they can accept deposits but cannot lend. Commercial banks do both.
• Development finance institutions (DFIs) such as IFCI, NABARD, SIDBI and NaBFID: they give long-term credit to high-risk sectors and do not accept deposits from the public [3]. Commercial banks depend on public deposits.
• Investment banks: they help companies raise money by selling shares and bonds. They do not take deposits and give loans the way commercial banks do.
• RBI: it is the regulator and central bank. It makes rules for commercial banks and supervises them. It does not take deposits from the public like a commercial bank.

Prelims Hooks

• Commercial banks take deposits and give loans. Through lending they create credit, so they are part of the money-creating system.
• Spread = loan rate − deposit rate. For example, lending at 10% and paying depositors 6% gives a spread of 4 percentage points.
• Payments banks cannot lend. Small finance banks lend mainly to small businesses and low-income groups. Both are types of banks.
• RBI's on-tap licensing guidelines for universal banks in the private sector are dated 1 August 2016, and they allow a NOFHC structure [2].
• Timeline: 1991 reforms opened banking to new private players → 1993 first new private bank licences → 2016 on-tap licensing. Foreign investment of up to 74% is allowed in private sector banks.
• Trap: ancient temples lent money but did not accept public deposits. DFIs also do not accept public deposits [3].

Mains Points

• Asset-liability mismatch in infrastructure lending (GS-III):
• Banks used short-term deposits to fund long-term projects such as highways.
• When those projects were delayed, loans went bad. This added to the NPA problem of the 2010s.

• NaBFID (2021) tries to fix this by raising long-term money and building the infrastructure bond market [3][4].

• Financial inclusion through many channels:

• Large commercial banks do not reach every village.
• RRBs, small finance banks, payments banks and post offices reach people who have no bank branch nearby.

• NABARD's refinance sends bank credit to farming and village industries.

• Banks as engines of growth (Schumpeter):

• Banks do more than move savings around. They create credit that pays for new businesses.
• Easier access to bank credit therefore supports entrepreneurship. This links to Start-up India and to MSME credit through SIDBI.
• More private banks since 1991, and on-tap licensing since 2016 [2], increase competition in banking and can widen access to credit.

Related concepts

• Financial infrastructure
• Financial sector
• Financial intermediation
• Private sector banks
• Development finance institution

Read more

• The financial system: banks and other institutions