Loan Activities of Banks - CBSE Class 10 Social Science

1. How Banks Use Deposits to Provide Loans

a. Accepting Deposits

Banks collect money from people who want to save their surplus money safely.
Types of deposit accounts include savings accounts, current accounts, fixed deposits, etc.
Depositors earn interest on their money, motivating them to save.
Example 1: Riya opens a savings account with ₹20,000 in the State Bank of India. She can withdraw money anytime and gets some interest.
Example 2: Rahul deposits ₹50,000 as a fixed deposit in HDFC Bank to earn higher interest over 1 year.
Example 3: A shopkeeper keeps his daily sale money in a current account for easy transactions.

b. Lending Money (Credit Creation)

Banks keep only a small part of total deposits as reserves (Cash Reserve Ratio - CRR) as mandated by the Reserve Bank of India (RBI).
The rest is lent to those who need funds for various purposes.
Banks act as intermediaries between depositors and borrowers, supporting economic activities.

Credit Creation Example:

A bank receives ₹1,00,000 in deposits.
It keeps ₹4,000 (4%) as reserve money.
It lends ₹96,000 to borrowers.
Borrowers spend this money, which goes back into the banking system as deposits.
This cycle repeats, increasing the total money supply.

2. Credit Creation

Meaning: When banks lend money, it eventually gets deposited back, allowing banks to lend again. This chain reaction increases the money in circulation. This process is called credit creation.
Mechanism: The bank lends most of the deposited money but keeps a small portion as reserves. Borrowers use the loan to buy goods or services, and the sellers deposit that money back into bank accounts. The bank again lends a percentage of this new deposit.

Example:

Priya deposits ₹10,000 in the bank.
Bank keeps ₹500 as reserve (5% CRR), loans ₹9,500 to Mohan.
Mohan spends or deposits ₹9,000 again in the bank.
Bank now keeps ₹450 as reserve and gives a loan of ₹8,550.
This cycle continues, multiplying the money supply.

3. Terms of Loans

Loans are given on conditions to ensure repayment and reduce risk for banks:

a. Interest

Interest is the extra amount paid by the borrower to the bank for using the loan money.
Interest rates differ based on the loan type, purpose, and banking policies.

Examples:

Home loan interest rate may be 8% per annum.
A personal loan may carry 12-15% interest per annum.
Agricultural loans may have subsidized interest rates, e.g., 4-7%.

b. Collateral

Collateral is a security asset the borrower pledges to the bank.
It can be land, house, vehicle, jewellery, etc.
If the borrower fails to repay, the bank can sell the collateral to recover the loan amount.

Examples:

Ravi uses his gold jewellery as collateral for a ₹50,000 loan.
Sohan offers his car as collateral for a business loan from the bank.
A farmer pledges his land documents to get an agriculture loan.

c. Documentation

Banks ask for identity proof, address proof, income statements, property documents, etc.
This helps verify the borrower's identity, income capacity, and credibility.

Examples:

For an education loan, the student must submit an admission letter along with parent's income proof.
For a home loan, property ownership papers and employer salary slips are essential.

4. The Dual Role of Banks

a. Accepting Deposits

Banks serve as a safe place to store money.
They offer various account types and pay interest on deposits.
This encourages savings among the public.

b. Providing Loans

Banks provide loans to individuals, businesses, and farmers who need money.
Interest on loans is higher than that paid on deposits.
The difference (called spread) covers bank expenses and profits.

Example:

HDFC Bank offers 4% interest on deposits but charges 10% on loans, earning a 6% spread.

Illustration: Credit Creation in a Small Town

Imagine 100 people each deposit ₹5,000 in a bank → total deposits = ₹5,00,000.
Bank keeps 5% (₹25,000) as reserves and lends out ₹4,75,000.
Mohan takes a loan to start a shop. He pays suppliers with this loaned money.
Suppliers deposit the money back into the bank.
Bank again keeps 5% reserves and lends the rest.
This process continues several times, increasing money flow and promoting economic activities.

Summary Table

Function	Example	Benefit
Accepting Deposits	Riya opens a savings account	Saves money safely, earns interest
Lending Loans	Mohan takes a business loan	Generates income and employment
Credit Creation	Deposits re-lent multiple times	Expands money supply, strengthens economy
Terms of Loan	Collateral, Interest, Documentation	Ensures loan repayment, minimizes risk

Key Concepts for Exams

Explain credit creation with examples.
Describe terms of loans: interest, collateral, and documentation.
Describe the dual role of banks: accepting deposits and lending loans.

Activity: Simulating Credit Creation

Objective: Understand how money multiplies through bank loans and deposits.

Instructions:

Imagine you have ₹1,000 initially deposited in a bank.
The bank keeps 10% as reserves (₹100) and loans out ₹900.
The ₹900 is spent by borrowers and then deposited back into the bank.
The bank keeps 10% of ₹900 (₹90) and lends ₹810.
This continues multiple rounds.

Observations to Note:

Each time, the bank keeps part of the deposit as reserves.
The amount lent out becomes new deposits, creating more loans.
Total money generated in the system is much higher than the initial deposit due to this process.

Example:

Round	Deposit Amount	Reserve (10%)	Amount Lent Out
1	₹1,000	₹100	₹900
2	₹900	₹90	₹810
3	₹810	₹81	₹729
...	...	...	...

Scenario Based Questions

Scenario: You want to explain how banks help small businesses grow in your town.
- Question: How do banks use deposits to support entrepreneurs?
- Answer: Banks collect deposits from savers, keep a portion as reserves, and lend the majority to entrepreneurs like Mohan to start businesses, generating jobs and income.
Scenario: Your cousin wants to take an education loan but is worried about loan terms.
- Question: What should you tell them about terms like interest and documentation?
- Answer: Explain that interest is the extra money paid for borrowing. Documentation (such as admission letter and income proof) helps banks verify the borrower’s ability to repay.
Scenario: You read that banks help create more money in the economy.
- Question: How does this process called credit creation work?
- Answer: Banks lend deposits to borrowers who spend the money. When this money is deposited back in banks, it can be lent again, multiplying the money supply.
Scenario: A farmer needs a loan but has no collateral to pledge.
- Question: What challenges might the farmer face?
- Answer: Without collateral, banks may be reluctant to grant a loan as there's no security if the loan isn’t repaid. The farmer may need to look for government schemes or co-operative banks with relaxed rules.
Scenario: A bank pays 5% interest on deposits but charges 12% on loans.
- Question: Why does the bank charge higher interest on loans?
- Answer: The higher loan interest covers risks, operational costs, and profits. The difference between loan and deposit interest (spread) keeps the bank running.