Loan Activities of Banks
What do banks do with the deposits they accept from the public? Banks keep only a small proportion of their deposits as cash — in India these days about 5 per cent — as a provision to pay depositors who may come to withdraw money on any given day. Since only some of the many depositors withdraw cash on a particular day, the bank manages comfortably with this small reserve.
Banks as Mediators
Banks use the major portion of the deposits to extend loans, because there is a huge demand for loans for various economic activities. In this way, banks mediate between depositors (who have surplus funds) and borrowers (who need funds).
Banks charge a higher interest rate on loans than the interest they pay on deposits. The difference between what is charged from borrowers and what is paid to depositors is the bank's main source of income.
Questions and Answers
Q1. How do banks mediate between those who have surplus money and those who need money?
Answer: Banks accept deposits from people who have surplus funds and pay them interest. They keep only a small cash reserve (about 5 per cent) and use the rest to give loans to people who need funds — the borrowers. In this way banks act as a link (mediator) between depositors and borrowers, channelling savings into productive loans.
Q2. What is the main source of income of banks?
Answer: Banks charge a higher rate of interest on loans than the rate they pay on deposits. The difference between the interest charged from borrowers and the interest paid to depositors is the bank's main source of income. This spread allows banks to cover their costs and earn profit while mediating between savers and borrowers.
Q3. Why do banks keep only a small proportion of their deposits as cash?
Answer: Banks keep only a small proportion of deposits (about 5 per cent in India) as cash because, on any given day, only some depositors come to withdraw money, not all of them. This small reserve is enough to meet daily withdrawal needs. The major portion is used to give loans, which earns interest — so keeping too much idle cash would waste the bank's ability to earn income.