The special, very strong and prominent monetary institutions that act as financial intermediaries in the monetary system with profit motive are called commercial banks.
Services provided by Commercial banks
Accepting deposits
Providing loans
Long term loans
Short term loans
Services as an agent
Common Utility services
Assisting in foreign banking activities
Providing pawning services
Providing safe keeping services
Providing related services in foreign currency transactions
Objectives of Commercial bank
To maintain liquidity
To maintain profitability
Statutory reserve ratio
According to the regulations of the Central Bank, commercial banks must maintain a certain percentage of its deposits as a reserve. This ratio is known as the statutory reserve ratio.
The Central Bank changes this ratio from time to time.
Excess Reserves
The amount of reserves exceeding the statutory requirement is called excess reserves.
Excess reserve = Current money reserve – Statutory reserve.
Excess reserve is determined based on the following factors:
The demand for loans
Selection of commercial banks between liquidity and profitability
Monetary policies of the Central Bank
Deposit Multiplier
Deposit multiplier is the number of times of expansion of deposit or creation of credit with a demand deposit.
Deposit multiplier is equal to the reciprocal of statutory reserve ratio.
Liquidity – Profitability
When liquidity is maintained profitability decreases and when profitability is maintained, liquidity decreases.
Since there is a clash between the two objectives, mentioned above, assets should be maintained in a balanced manner.
Credit Creation
Generating more deposits than the existing deposits by lending the excess reserves of commercial banks is called Credit creation.
Since only one bank functions in a monopolistic banking system, credit creation is possible. But it is impossible for a single bank in a banking system to create money.
The credit creation of the commercial banking system is based on the following assumptions:
After making the initial deposit there is no inflow or outflow of money in the banking system
All the borrowers deposit their total amount of loans in another commercial bank
No bank maintains excess reserves
There are limitations to credit creation as follows:
If people prefer to retain money with them, excess reserves of commercial banks will decline
Credit creation decreases when banks prefer to maintain excess reserves
