Opinion – The role of a commercial bank in the modern financial system

Kasika gift

The activities of commercial banks as we know them today date back to the 1200s, when merchant trade spread to wider geographic areas. Money as we know it today is a different concept than it was in the days of the merchants although it retains its basic function from yesterday to today.

Money and money are different concepts although they are closely related. Cash generally refers to money that an individual is currently in possession of in physical form, including banknotes and coins only. Currency, on the other hand, is a broader term, which includes all liquid and semi-liquid assets such as notes, stocks and money market securities which are generally accepted and recognized by law as a means of payment for goods and services. In the analysis that follows, the difference between silver and silver shall apply.

The financial system is the main engine of economic development of any nation, at the center of the financial systems are the commercial banks. Commercial banks are the intermediary institutions primarily responsible for channeling financial resources from lenders to investors, albeit indirectly.

Banks accept deposits of different maturities and from these make loans to borrowers/investors deemed creditworthy, which creates money through fractional reserve banking.

These functions of commercial banks are an important element for economic growth. If the economy is left alone, it would be difficult and time-consuming for economic agents to negotiate directly, to assess the creditworthiness of borrowers, which therefore means that resources would not be used in the best possible way.

Lenders should assess the creditworthiness of potential borrowers and observe that their funds are being used for the intended purpose, take steps to ensure that borrowers do not run away with the loan, etc. Financial intermediaries such as banks have mechanisms and security elements that reduce the risks and costs associated with loans.

Commercial banks assess the above in a short period of time compared to what they would be if economic agents assessed themselves.

The term fractional reserve banking is derived from the fact that only a fraction of bank deposits are provided with a reserve of cash in bank vaults. The public can use their deposits to settle payments between themselves and their deposits can be convertible into cash on demand, even if they are not 100% guaranteed by cash.

The money that a fractional reserve bank keeps aside to meet the demand for cash withdrawals as well as interbank cash payments is called cash reserves or bank reserves.

The need to hold cash reserves stems from the fact that deposit holders have the right to convert their deposits into cash and the right to direct their bank to make payment to deposit holders in other banks, which which requires interbank cash payments. Banks must therefore be able to meet these requirements.

The reserve bank is further facilitated by the fact that other withdrawals have a notice period before real money can be released and the bank can borrow from other banks or from the central bank in the event of cash shortage.

Monetary creation

The role of commercial banks in relation to fractional reserve banking is very important in a modern economy, banks increase purchasing power. Fractional reserve banking holds the ability to create money.

Banks accept deposits from the public and keep a certain percentage of their deposits as cash reserves, the remaining amount is loaned out or used in income generating activities.

The monetary expansion does not stop there, once the excess amount is lent out, a new wave of money creation begins as the lent money is then deposited in another bank which will also hold a fraction of the amount and issue the remaining balance as loans.

The process will continue in this way until the initial sum deposited is exhausted and the monetary balance of the economy is expanded, at the end of the process the expansion of the money as a whole can go up to a maximum 20 times the initial deposit.

Cash held by the commercial bank is called high power money because it has the ability to increase purchasing power within the economy.

The main activity of commercial banks is to lend the deposits they receive with interest, apart from the interest earned from lending on deposits, commercial banks engage in other activities such as investing in properties such as real estate and thus the issuance of mortgage loans for profit.

Commercial banks also finance the purchase of properties such as vehicles on behalf of their customers and receive long-term repayments for a profit. Of all the other functions, fractional reserve banking is the most important element in an economy, as you can see above, for those who cannot differentiate a commercial bank from others, this specific function is the main one definition and it is therefore one of the particularities that differentiate a commercial bank from a development bank and from all the other financial institutions.

It is only one commercial bank having this particularity in the whole financial system. The fractional reserve system is a catalyst for the economic development of any modern economy.

2022-11-16 Staff reporter

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