Explain how banks earn profit.



Points to Remember:

  • People deposit their savings in banks and earn an amount as interest .
  • Banks keep a small portion of their deposit as reserves . Banks keep this deposit to meet the regular demand for withdrawal .
  • The RBI monitors banks and ensures that they are keeping these reserves .
  • Majority of the deposit is used to meet the loan requirement of borrowers .
  • Banks act as a mediator .
  • RBI ensures that banks give loans not only to profit-making businesses but to small-scale industries and farmers too.
  • Banks charge more interest on loans from borrowers than it pays to their depositors and the difference is what banks keep as their profit .

Answer to be written:

  • People only need some amount of money for their day-to-day needs.  
    • For instance, workers who receive their salaries at the end of each month have extra cash at the beginning of the month. They deposit it with the banks by opening a bank account in their name. Banks accept the deposits and also pay an amount as interest on the deposits. In this way, people’s money is safe with the banks and it earns an amount as interest . People also can withdraw their money as and when they require it.
  • Banks keep a small portion of these deposits as a cash reserve ratio of about 15% (this ratio is at 5% today) to meet the regular demand of withdrawal of customers. Since banks have a huge number of depositors and not everyone withdraws their deposits regularly banks only keep a small portion of their deposits.
  • Banks use the major portion of the deposits to extend loans. There is a huge demand for loans for various economic activities. Banks make use of the deposits to meet the loan requirements of the people.
  • That’s how banks act as a mediator between those having a surplus amount of funds (depositors) and those who need those funds (borrowers).
  • Banks charge higher interest rates on loans than what they offer on deposits . The difference between what is charged by borrowers and what is paid to depositors is their main source of income or profit.
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Davneet Singh

Davneet Singh has done his B.Tech from Indian Institute of Technology, Kanpur. He has been teaching from the past 14 years. He provides courses for Maths, Science, Social Science, Physics, Chemistry, Computer Science at Teachoo.