Loan Activities of Banks — Money and Credit: Long Answer Questions
Medium Level (Application & Explanation)
Q1. Explain why people deposit money in banks and compare the main types of accounts with suitable examples.
Answer:
People deposit money in banks for three main reasons: safety,
Q2. “Banks keep only a fraction of deposits as reserve and lend the rest.” Explain this practice and its importance with a number example.
Answer: Banks follow a fractional reserve system. They do not keep all deposits as cash; instead, they hold a small fraction as reserve for daily withdrawals and lend the remaining amount. This reserve is mandated by the RBI through ratios like the Cash Reserve Ratio (CRR). For example, if total deposits are ₹1,00,000 and CRR is assumed at 4%, the bank keeps ₹4,000 as reserve and can lend ₹96,000. Reserves maintain liquidity and trust, ensuring customers can withdraw on demand. Lending the rest keeps money active in the economy, helping people buy homes, start shops, or fund farming. During busy seasons like festivals, banks may hold slightly more cash to meet increased withdrawals. This balance between safety (reserves) and growth (lending) is essential to smooth banking operations and public confidence.
Q3. Describe how banks create credit through the money multiplier process. Use a simple flow to show how an initial deposit grows into larger total lending.
Answer: Banks create credit when loaned money is spent and re-deposited into the banking system, allowing further lending. Suppose Priya deposits ₹10,000. The bank keeps a small reserve and lends the rest to Mohan. Mohan pays a shopkeeper, who deposits the money again. The bank again keeps a reserve and lends the balance further. This chain repeats across many rounds. Although some cash may be held outside banks (leakages), most funds return as new deposits, enabling fresh loans. The size of this money multiplier depends on the reserve ratio—a higher ratio slows the chain, while a lower ratio accelerates it. Even with leakages, total credit created becomes larger than the initial deposit. In a town, if many people deposit ₹5,000 each, the combined cycle supports traders, transporters, and farmers. This process spreads benefits widely, turning one deposit into many productive loans across the local economy.
Q4. What are the main terms of a bank loan and why do banks check them carefully? Illustrate with examples of home, education, and gold loans.
Answer: A bank loan has four key parts. First, interest: you repay the principal plus extra money called interest; rates vary by loan type—personal loans are costlier than home loans. Second, collateral: an asset like land, house, gold, or vehicle pledged as security. If you default, the bank can sell the collateral to recover money. Third, documentation: banks perform KYC (ID, address), check income proof, and verify property papers for housing loans. Fourth, repayment: most retail loans use EMIs and may need a guarantor or margin money. For example, Anita takes a home loan at 8% p.a., mortgages her flat, and pays EMIs for 20 years. Rohan’s education loan begins repayment after his course ends, based on admission and income proofs. Meena’s gold loan is short-term; she pledges jewellery and gets it back after full repayment. These checks protect both the borrower and the bank.
Q5. What is the dual role of banks in the economy? Explain the concept of “spread” with reasons why it matters for stable banking.
Answer: Banks play a dual role: they collect deposits and lend loans. On deposits, banks pay interest; on loans, they charge higher interest. The difference between the lending rate and the deposit rate is called the spread. For example, a bank may pay 4% on savings deposits but charge 10% on business loans, creating a 6% spread. This spread covers operational costs like branches, staff, ATMs, technology, and risk provisions, and it provides profit to stay stable. A healthy spread ensures banks can expand services, serve more customers, and handle bad loans or economic shocks. It also allows banks to offer lower rates to low-risk borrowers (salaried) and charge higher rates to higher-risk borrowers, balancing safety and inclusion. Without a reasonable spread, banks cannot function sustainably or support long-term financial growth.
High Complexity (Analytical & Scenario-Based)
Q6. CRR in a country rises from 4% to 6%. Analyse how this change affects credit creation, lending to small businesses, and overall local economic activity.
Answer: When CRR increases from 4% to 6%, banks must keep a larger share of deposits as reserves, leaving less to lend. This directly reduces the money multiplier, slowing credit creation. Small businesses depending on bank loans for working capital may find it harder to access funds or face higher interest rates, as credit becomes relatively scarce. With fewer loans, shops delay expansion, farmers postpone buying inputs, and households reduce big purchases. In the short run, this can lower consumption, investment, and job creation in the locality. However, higher reserves also strengthen liquidity and stability, reducing the risk of cash shortages during heavy withdrawals. The overall impact is a trade-off: improved safety for the banking system but slower growth in lending-supported activities. Policymakers use CRR changes to balance inflation control and economic momentum.
Q7. Two borrowers apply for loans: A salaried teacher with property papers, and a new entrepreneur with no collateral but a solid business plan. As a banker, what will you check, and how might terms differ?
Answer: A banker first verifies purpose, repayment capacity, documentation, and risk. For the salaried teacher, stable income slips, good credit history, and property collateral reduce risk. The bank may offer a lower interest rate, longer tenure, and standard EMIs. For the entrepreneur, absence of collateral raises risk despite a good plan. The bank will check projected cash flows, market demand, and management capability. Possible options include a smaller loan amount, a guarantor, higher interest, or asking for margin money. The banker may also suggest government-backed schemes or startup credit guarantees that relax collateral. Documentation such as KYC, income proofs (where available), and registrations are essential. The final decision balances safety and growth: fund viable ideas without endangering depositors’ money. Thus, terms differ based on risk, security, and repayment visibility.
Q8. Your friend argues that bank loans help only the immediate borrower. Use the idea of credit creation and local linkages to counter this claim with a realistic chain of effects.
Answer: The benefit of a loan extends far beyond the immediate borrower through credit creation and local linkages. Suppose Mohan takes a loan to open a shop. He pays suppliers, who then deposit receipts back into banks, creating new deposits that fuel more lending. Mohan hires a helper, generating employment and household income. The helper spends at the local market, boosting sales for other vendors. Those vendors deposit their earnings, enabling further loans to transporters or tailors. As business taxes rise, public services may improve. Farmers financed by banks buy better seeds and irrigation, raising output and supplying Mohan’s shop reliably. This cycle shows a loan becomes someone else’s income, which becomes another deposit, creating a larger circle of opportunities. Hence, bank lending sparks a multiplier effect across jobs, production, services, and community welfare.
Q9. Imagine a festival week with high cash withdrawals in your town. Explain how banks manage liquidity, maintain trust, and still continue lending without causing “no cash” situations.
Answer: During festivals, withdrawals surge. Banks manage this by holding adequate reserves—some cash in vaults and required balances with the RBI—to meet daily cash needs. They forecast demand using past data and ensure ATMs and branches are funded. The fractional reserve system allows banks to keep only a small fraction as cash while lending the rest. By maintaining the mandated CRR, banks protect liquidity and trust so customers never face “no cash” notices. Simultaneously, the ongoing stream of deposits from businesses and salaries replenishes funds, supporting continued lending. In extreme cases, banks can reallocate cash across branches or access inter-bank liquidity. Clear communication with customers, robust cash logistics, and prudent risk management ensure stable services. Thus, even with high withdrawals, banks balance safety and credit flow to keep the local economy running smoothly.
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