Gift Kasika

The activities of commercial banks as we know them today date back to 1200s during the periods when merchants’ trading were expanding to wider geographical areas. Money as we know it today is a different concept from what it was during the period of merchants although it retains its basic function from then to today. 

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

The financial system is the main driving force for the economic development of any nation, on the centre of the financial systems are commercial banks. Commercial banks are the intermediary institutions mainly responsible for channeling financial resources from lenders to investors although in an indirect way. 

Banks accept deposits of different maturity periods and from them issue out loans to borrowers/ investors who are deemed credit worthy, in the process they create money through fractional reserve banking. 

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

 Lenders would have to assess the credit worth of potential borrowers, and observe that their funds are used for the intended purposes, take measures to insure that borrowers do not abscond with the loan and so forth. Financial intermediaries such as banks have mechanisms and security elements which reduce the risks and the costs involved in lending.

 Commercial banks assess the above within a short space of time compared to what would be if economic agents assess themselves.

The term fractional reserve banking is derived from the fact that only a fraction of the bank deposits are being provided with cash back-up in the bank vaults. The public can be using their deposits for settling their payments amongst themselves and their deposits can be convertible into cash on demand even though they are not 100% backed by cash. 

The cash 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 arises because deposit holders have the right to convert their deposits into cash and the right to order their bank to make a payment to deposit holders at other banks, which requires inter-bank cash payments. Banks therefore have to be in a position to meet these demands. 

The reserve banking is further facilitated by the fact that other withdrawals have a notice period before actual cash can be paid out and the bank can borrow from other banks or from the central bank in case of cash shortages.

Money creation

The role of commercial banks in relation to fractional reserve banking is very important in a modern economy, banks expand the purchasing power. The fractional reserve banking holds the possibility of creating money.

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

The money expansion doesn’t end here, once the excess amount is loaned out, a next wave of money creation begins as the money loaned is further deposited in another bank which will as well keep a fraction of the amount and issue the remaining balance as loans.

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

Cash held by the commercial bank is referred to as high powered money because it has the capability to expand the purchasing power within the economy. 

Commercial banks’ principle business is to lend the deposits they receive at an interest, besides the interest from deposit lending, commercial banks engage in other businesses such as investing in properties such as real estate and thereby issuing mortgage loans at a profit.

Commercial banks also finance the purchase of properties such as vehicles on behalf of their clients and receive long term repayments for a profit. Amongst all other functions, the fractional reserve banking is the most important element in an economy as I am sure you can see from above, for those who can’t differentiate a commercial bank from others, this specific function is the main defining and it’s therefore one of the special features that differentiate a commercial bank from a development bank and all other financial institutes. 

It’s only a commercial bank having this special feature in the whole financial system. The fractional reserve system is a catalysis for economic development of any modern economy.