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Money and Credit – Loan Activities of Banks

Medium Level (Application & Explanation)

Q1. Explain how banks accept deposits and why people keep money in banks. Give examples.

Answer:

  • Banks accept deposits from people who have surplus money.
  • They offer savings, current, and fixed deposit accounts.
  • People deposit money for safety, easy withdrawals, and interest.
  • A savings account gives low but regular interest and ATM access.
  • A fixed deposit gives higher interest but locks money for time.
  • Example: Riya opens a savings account and deposits ₹20,000.
  • She can withdraw anytime and earns some interest on it.

Q2. Describe how banks use deposits to provide loans. What is CRR? Give a simple example.

Answer:

  • Banks do not keep all deposits idle. They keep only a fraction as cash reserve.
  • This fraction is the Cash Reserve Ratio (CRR) set by the RBI.
  • The remaining money is used to give loans to people and businesses.
  • Example: If deposits are ₹1,00,000 and CRR is 5%, bank keeps ₹5,000.
  • It can lend ₹95,000 to a borrower.
  • Thus, banks act as intermediaries between depositors and borrowers.
  • This process helps circulate money in the economy.

Q3. What is credit creation? Explain the chain effect with a classroom-style example.

Answer:

  • Credit creation means banks increase money supply through lending.
  • Loans given by banks are spent and then re-deposited in banks.
  • A part is kept as reserve, and the rest is lent again.
  • Example: Priya deposits ₹10,000. Bank lends ₹9,500 to Mohan.
  • Mohan pays a shop, and ₹9,500 is deposited again.
  • Bank keeps reserve and lends the balance again.
  • This repeated process makes money multiply in the system.

Q4. Explain the main terms of loans: interest, collateral, and documentation. Give examples for each.

Answer:

  • Interest is the extra amount paid over the principal.
  • Rates vary by loan type (home, personal, education).
  • Collateral is an asset kept as security (house, land, car, gold).
  • If one fails to repay, the bank can sell the collateral.
  • Documentation includes ID proof, address proof, income proof, and property papers.
  • Example: Ravi pledges gold for a short-term loan.
  • For a home loan, banks check salary slips and property papers.

Q5. State the dual role of banks and explain how banks earn profit through the spread. Give a clear example.

Answer:

  • Banks have two core roles: accepting deposits and providing loans.
  • They pay interest on deposits to savers.
  • They charge higher interest on loans from borrowers.
  • The difference is called the spread.
  • Spread covers costs and gives profit to banks.
  • Example: If bank pays 4% on deposits and charges 10% on loans, spread is 6%.
  • This spread helps banks run operations and expand services.

High Complexity (Analysis & Scenario-Based)

Q6. A town deposits ₹5,00,000 in a bank. If CRR is 5%, show the first two rounds of lending. How does this help the local economy?

Answer:

  • Total deposits = ₹5,00,000. CRR = 5%, so reserve = ₹25,000.
  • First loan possible = ₹4,75,000 to a shopkeeper.
  • The shopkeeper pays suppliers. They deposit the money back.
  • Second round deposits ≈ ₹4,75,000. Reserve now ≈ ₹23,750.
  • Second loan possible ≈ ₹4,51,250 to another business.
  • Money flows to wholesalers, workers, and transporters.
  • It boosts trade, jobs, and income in the town.

Q7. Sohan fails to repay his business loan. Explain how collateral and documentation protect the bank. What steps follow?

Answer:

  • Sohan had given collateral (say, his car) for the loan.
  • The bank has legal rights over the collateral if he defaults.
  • Due to documentation, the bank can trace Sohan and the asset.
  • The bank sends notices, allows time, and then may seize the asset.
  • It can sell the collateral to recover the loan amount.
  • Proper papers reduce fraud and support legal action.
  • This protects the bank’s money and keeps the system trustworthy.

Q8. RBI raises CRR from 4% to 6%. Analyze the impact on bank lending and credit creation with a short example.

Answer:

  • A higher CRR means banks must keep more reserves.
  • Less money is left for loans to the public.
  • Example: On ₹1,00,000 deposits, reserve rises from ₹4,000 to ₹6,000.
  • First-round lending falls from ₹96,000 to ₹94,000.
  • The whole credit chain becomes smaller.
  • Fewer loans mean slower spending and slower business growth.
  • It helps control inflation but may reduce new investments.

Q9. A bank pays 3% on deposits and charges 11% on loans. Explain the spread and its effects on savers, borrowers, and the bank.

Answer:

  • Spread = loan rate − deposit rate = 11% − 3% = 8%.
  • Savers earn 3%, so they get safety and liquidity, but low returns.
  • Borrowers pay 11%, so loans are costly but enable growth.
  • The bank uses 8% spread to pay staff, rent, technology, and taxes.
  • It also covers bad loans and keeps profits for stability.
  • A fair spread keeps services running and branches open.
  • Very high spreads can hurt borrowers; very low spreads can hurt banks.

Q10. Ritu needs ₹5 lakh for a shop. Option A: secured loan at 8% with collateral. Option B: unsecured loan at 12% without collateral. Advise with reasons.

Answer:

  • Option A has lower interest (8%) but needs collateral.
  • Option B has higher interest (12%) but needs no collateral.
  • If Ritu has an asset (like gold or property), Option A is cheaper.
  • Lower rate means smaller EMIs and lower total cost.
  • If she lacks collateral but needs quick funds, Option B works.
  • She must check repayment capacity and business cash flow.
  • Safer choice: choose Option A if collateral is available and income is stable.

Q11. A bank sees a sudden rise in deposits during festival season. Explain how it can manage reserves, lend safely, and maintain profit.

Answer:

  • The bank must first meet CRR and keep enough cash.
  • It should lend to creditworthy borrowers using documentation checks.
  • It can offer short-term loans for inventory and festive sales.
  • It must keep some liquidity for withdrawals during the season.
  • It should price loans to keep a healthy spread and cover risks.
  • Diversifying loans reduces default risk and protects profits.
  • Careful planning keeps both customers and bank safe.

Q12. A locality prefers keeping cash at home, not in banks. Analyze the impact on credit creation and local development.

Answer:

  • Cash at home does not become deposits for banks.
  • With low deposits, banks cannot lend much.
  • Credit creation stays weak, so the money does not multiply.
  • Fewer loans mean fewer shops, start-ups, and jobs.
  • Local people miss interest and safety that banks offer.
  • Encouraging banking habits boosts savings and growth.
  • More deposits lead to more loans and a stronger economy.

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