Q21 Do banks lend out more money than is entrusted to them by depositors?

1273622, RAVNEET KAUR, F2

Q21      Do banks lend out more money than is entrusted to them by depositors?

                                        

Introduction

Segment-1

The basic function of the Banks is to take the deposits from the customers (those who have some surplus funds with them to keep it in a safe and to get some profit/interest on it) on some consideration and lend it out to the borrowers who eventually require the funds and in consideration they give some interest/charges over and above the amount they took as a loan from the Banks.

By paying depositors a lower interest than they charge from their borrowers, the Banks make a profit.

Primarily, the Banks lend out money from the deposits, and gain some profit/interest. However, if the Bank misjudges the proportion to be lent out from the deposits, the Banks would certainly go burst and the Banks would definitely lose its credibility and confidence in its ability ultimately, the depositors (customers) would step back from availing its services.

And in case the Banks also over-evaluates the creditability of the borrower and the Non-Performing Assets go on increase, the Bank would certainly face a financial crunch which would affect its working as well as its existence.

Therefore, in no case the Bank is allowed to lend out the whole of the deposits as the customers may demand their money back at any time, the Bank has to manage the proper ratio in order to maintain the inflow and outflow of the funds as per the first requirements of its customers and indeed while managing its profitability altogether. And also the Banks have no much scope to bear the burden of Non-Performing Assets, as it would not only be detrimental to the profitability of the Banks but also it would be detrimental to the interest of the customers, whose money is involved in the Non-Performing Assets in larger proportion.

The other aspect to look into is that the Banks in India are governed as per the norms or regulations as issued time to time by the Reserve Bank of India and much similar case is in the World over as the other Nationalized Banks are governed by some Central or Federal Bank in order to bring equality in the norms and to protect the rights and money of the customers of the Banks.

Therefore, in conformity to the Reserve Bank of India, the Indian Banks have to have some Cash Reserve Ratio, it is the part of the deposits which cannot be lent out in any case except the Reserve Bank of India permits other way by any notification.

In this manner, the Banks have to bring a break even point where they can easily lend out the funds without harming the customers requests for the return from time to time. So the Banks will have to take care of the directives of the Reserve Bank of India as well, in case of Indian Banks.

The lending capacity of a Bank in India would be as under:

Deposits-CRR-Break Even Amount (to satisfy the customers demands) = Lending Capacity

As per the above formula, assuming a Banks gets deposits INR 100 Crores at a particular time, and the lending capacity would be as under:

100-CRR-Break Even Amount = Lending Capacity

Note: the CRR is always percentage based of the Deposits

Segment-2

There is another aspect to look into is that the above mentioned equation is very traditional in approach as the Banks have developed and their criterion of working and providing services has expanded so widely and it leads to heavily increase in the profitability of the Banks and ultimately in the capital formation.

The traditional approach is no doubt very true but the undeniable fact is also available is that the Banks are no more just Banks of taking and lending money only, now they have evolved into new sectors as well as provide many other ancillary and complementary services to its depositors as well as borrowers.

Even a large range of economists also emphasize on the aspect that the Banks can and do ‘create money out of nothing’, and do not have to wait for deposits before they make loans. And this particular connotation has been affirmed and propagated by the famous economists including Schumpeter, Von Mises, and Keynes.

They state that the Banks can make money out of nothing as they have good links with the other Banks and they can take advantage of the situation by using their links and association with other Banks or Financial Institutions. As they can take money from other Banks or Institutions and give it to their borrowers for a very shorter period in order to get good returns/rate of interest.

And it is also undoubted that as the range of services provided by the Banks have expanded and they even work as Merchant Bankers, Insurers, Brokers and so on therefore, the profitability of the Banks has increased manifold which also results into capital formation. And the Banks do utilize this amount by investing into securities and by increasing their lending capacity therefore, getting more interest and profits.

In this manner, the Banks capacity of lending increases much much more than ever expected as now the Banks can lend money even when they have less deposits as they have their own money as well and also it is pertinent to mention that they also take advantage of the situation to make profits even when they don’t own any funds by taking it from their sources such as other Banks or Institutions.

                                                 Discussion

In order to discuss it in detail, we have to first be clear on the following aspects:-

Part-1

The Banks lend out from the deposits, not only this

Part-2

The Banks lend out from their own profits/capital formed, and also

Part-3

The Banks lend out of nothing.

Part-4

And they make money out of all this.

Part-1

Banks actually create money out of something. The question is, what is that something, and what is wrong with it?

The Banks basically and initially lend out from deposits only. As the deposits increase the lending out capacity of the Banks also increases. This is a simple and ordinary connotation therefore it does not require much description.

Part-2

The Banks lend out from their own profits/capital formed by them.

The foremost question arises is that how the Banks make profits?

The answer is here, First, the Banks make profit when they lend out the funds, this is the consideration paid by the borrower to the Bank for the loan facility. Therefore, the Banks earn interest/profit from loans. Secondly, the Banks also provide many other services thesedays such as merchant bankers, brokers, commission agents etc. and in this way they earn big bunch money and that is also further invested into securities/shares and also lent out for more interest and dividends.

The short answer is that banks create money on the basis of the promises of their borrowers to repay.

In this manner, the Banks make a lot of money and it is extra source of lending than the deposits.

Part-3

The Banks lend out of nothing, as the world has become a colony so is in the case of Banks, they use their links and associations with other Banks or Institutions to take advantage of the situation and they lend out for shorter period in a few particular cases at higher rate of interest, in this way they lend out of nothing.

Part-4

And similarly, in this manner the Banks create funds and earn funds and also they earn out of nothing as well. And they also make profits by providing large number of services these days such as Merchant Bankers, Brokers, Commission Agents, Underwriters, Hedging Services, Investment and others.

                                  

Conclusion

It is true that banks make money from the difference between what they have to pay in interest from wherever they get their money from and what they receive in interest from whoever they lend money to - but because the order of events (borrow-then-lend vs. lend-then-borrow) can occur either way round, it is also true that banks can create money out of nothing... The Banks lend out of nothing, as the world has become a colony so is in the case of Banks, they use their links and associations with other Banks or Institutions to take advantage of the situation and they lend out for shorter period in a few particular cases at higher rate of interest, in this way they lend out of nothing.

And similarly, in this manner the Banks create funds and earn funds and also they earn out of nothing as well. And they also make profits by providing large number of services these days such as Merchant Bankers, Brokers, Commission Agents, Underwriters, Hedging Services, Investment and others.