Role of Commercial Banks in Economic Development
The role of commercial banks in
economic development rests chiefly on their role as financial
intermediaries. In
this capacity, commercial banks help drive the flow of investment capital throughout the marketplace. The chief mechanism of this capital allocation in the economy is through the
lending
process which helps commercial banks gauge financial risk.
01. Arbiters of risk:
One of the most significant roles of commercial banks in economic development is as arbiters of risk. This occurs primarily
when banks
make
loans to businesses or
individuals.
For instance, when individuals apply to borrow money from a
bank, the bank examines the borrower's finances, including
income, credit score and debt level, among other factors. The outcome of this analysis helps the bank gauge the likelihood of borrower default. By weeding out risky borrowers, commercial banks lessen the risk of financial losses. As a result, loans that mature without any problems generate a larger pool of funds for the bank to lend, further supporting economic development.
02. Generation of economic activity from individuals:
When commercial banks assess risk, they help
ensure that loans go to creditworthy borrowers. In turn, borrowers typically use loan proceeds to
finance major purchases, such as homes, education and other consumer spending.
The
effect
of commercial
bank lending generates economic activity from individuals who now have the necessary funds to finance their own endeavors.
03. Financing in Small Business:
Commercial banks also finance business lending in a
variety of ways. A business owner may solicit a
loan to finance the start-up costs of a small business. Once funded, the small business may begin operations
and embark on a
growth plan. The aggregate effect of small business activity generates a
significant portion of employment around the country. According to the
U.S. Census Bureau, businesses employing between one and 19 people accounted for 4.4 million
jobs in 2004. In contrast, businesses with more than 20 employees only accounted for 1.2 million in the same year.
04. Help Government Spending:
Commercial banks also support the role of the government as an agent of economic development. Generally, commercial banks help fund government spending by purchasing bonds issued by the Department of the
Treasury. Both long and short term Treasury bonds help finance government operations, programs and support deficit spending.
05. Generates Individual Wealth:
Commercial
banks
also offer
types of
accounts to hold or generate individual wealth.
In turn,
the deposits commercial banks attract with account services are
used for lending and
investment. For example, commercial banks commonly attract deposits by offering a
traditional menu of savings and checking accounts for businesses and individuals. Similarly, banks offer other types of timed deposit accounts, such as money market accounts and certificates of deposit. Some investors use these interest bearing, low risk accounts to
hold money for investment purposes, waiting for attractive investment opportunities to materialize
(ii) Banks
help
in distribution of
funds
between regions:
Another
way
by which commercial
banks
encourage
production
and
enhance national income
is by the transference
of surplus
capital from regions where it is not wanted so much, to those regions where it can be more usefully and efficiently
employed. This distribution of funds between regions has the effect of opening up backward regions
and paying the way for their economic development.
(iii) Banks create credit and help in business expansion: Fluctuations in bank credit have an
important bearing on
the level of economic activity. Expansion of bank credit will provide more funds to entrepreneurs
and, hence, will
lead to more investment. Under
conditions of
full
employment,
expansion of bank credit will have the effect of inflationary pressure. But under conditions of unemployment, it will push up production in the country. On the other hand, a decline in bank credit will result in
decline in production, employment, sales and prices. From the view of an under-developed economy, the expansion of bank credit offering more financial resources to
industries in one of the contributory causes for greater economic development.
(iv) Banks monetize debt: A very important service the banks render to the community is the creation
of demand deposits in exchange of debts of other (viz., short and long-term securities). Commercial
banks buy debts of others which are
not generally acceptable as money, either because the debtors are not sufficiently known or because their debt is payable only after a period of time. In return for them, they issue demand deposits which are generally accepted as money. By these exchange operations, banks monetize debt. The significance of banks today flows from the fact that they are “not merely traders in money but also, in
an important sense, manufacturers of money.” Bank money is used for the promotion of industry and trade. It is rightly said that they have not only the power to det ermine the aggregate volume of bank money in existence but to influence the uses to which that money should be put.
(v) Banks promote capital formation: Commercial banks afford facilities for saving and
thus encourage habits of thrift and industry among people. The mobilize the idle and dormant capital of the community
and make it
available for productive purposes. Economic development depends upon the diversion of economic resources from consumption to capital formation. A higher rate of saving and investment is, therefore, what constitutes real capital formation. In this, the
role of banks is invaluable. But then there can be other institutions also in a country such as insurance companies which may help in mobilizing
the savings of the community for productive purposes.
(vi) Banks influence interest rates : Banks can influence economic activity in another way also. They can