Learning Objectives:

  • Explain financial intermediation and its importance.

  • Understand how commercial banks create money.

  • Describe the role of banks in economic growth.

2.1 Financial Intermediation

Commercial banks serve as financial intermediaries by channelling funds from savers (depositors) to borrowers (individuals and businesses seeking financing) . This process is essential for economic growth because it allocates capital to its most productive uses.

As Britannica notes: “Commercial banks are financial intermediaries. They collect deposits from customers and use those funds to provide loans and other forms of financing. For example, a depositor may be saving for a large purchase or building an emergency fund, while a borrower may be buying a home or starting a small business. The bank connects the two” .

2.2 Money Creation and the Fractional Reserve System

Commercial banks operate under a fractional reserve system, meaning they hold only a portion of customer deposits in reserve while lending much of the rest . As loans are made and repaid, commercial banks expand and contract the supply of money and credit in the economy . When you deposit $10,000 in a bank, the bank keeps a fraction as reserves and lends out the rest. The borrower spends the loan proceeds, and the recipient of those funds deposits them at their bank. This cycle multiplies the original deposit into a larger total amount of money in circulation, a process known as the money multiplier .

2.3 Banks and Economic Growth

The Oxford Handbook chapter on commercial banking emphasizes banks’ role in the financing of industry and, more generally, in economic growth . Banks support economic growth by :

  • Channelling savings into productive investments.

  • Providing working capital for businesses.

  • Facilitating trade and commerce through payment systems.

  • Supporting innovation and entrepreneurship through access to credit.

The University of Edinburgh course requires students to “give students a broad understanding of the roles of banks and the structure of the banking industry in different countries” .

2.4 State Regulation and Responsibility

The development of commercial banking has been shaped by state regulation, primarily dictated by concerns about banks’ position as deposit takers . This regulatory oversight reflects the recognition that banks play a critical role in the economy and that their stability is essential for economic wellbeing. The changing nature of state regulation and banks’ role in economic growth has shaped the development of commercial banks since the onset of industrialization .

 

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