Ever wondered why so many private banks have emerged in the recent years? Ever wondered how banks manage to give loans for so much money? Ever wondered how the money we deposit in the bank is in turn utilized by the bank? Read on!
Banking is a business. It has to have a capital, profit, good maintaining, etc. like any other business. Mainly, the business involved with the banks is that the money deposited in the bank by the depositors is lent out at a higher rate of interest while paying a small interest to the depositor. The money deposited in the savings account should stay there for some time, like a predetermined period of time in order to get the interest for the depositor.
The money deposited in the current account will not get any interest as it could be taken back any time and the bank cannot take that money away for lending it out.
The success of the banking as a business is determined on the capability of the bank in keeping a balance between profitability and liquidity. They have to lend out money to get higher interest and also they have to make the depositor be able to take out as much as money as he wants to, at any point in time. How does this work? All the people who deposit money in a bank will not need the whole money at one time. So what they do is that, they keep a liquidity of around 10% at any time and the rest they use to give loans and get higher interest and thus making a profit.
So this is a process of inflow and outflow of cash and it could get into a halt any time. Like for example if there is a shortage of deposits, it affects the process of lending out loans also. So there are a few situations where the bank becomes unable to maintain this inflow/outflow balance. Let us see what they are.
First is when they want to increase the reserve ratio, i.e., the money they keep aside for emergency or liquidity is raised to 15% or 20%, then there could be a shortage to enable the outflow of money.
Second is that the loans can be given only when there are investment opportunities in the society. If recession hits and people are short of money to start any new business venture or building houses etc., it will affect the bank as there will not be any takers for the loan.
The third situation is that lack of proper securities with which the banks create deposits. If the volume of securities that yields income is unavailable, then it limits the creation of deposits.
The fourth is that, as the money supply increases in the society, people may demand more cash from the bank to buy goods or services. This deficit of cash from the banks will reduce the cash reservoir of the bank, thereby limiting the outflow.
Finally, the power of the bank to create deposits is often restricted by the Government policies. This will in turn affect the credit creating capacity of the bank.
These are the basics of the banking system, which each one of us should be aware of, as this is a time where we cannot find a single person who does not have a bank account or who does not have transactions with the banks.