The place of the commercial banks in the British economy is a very important one. They stand at the very centre of business activity and can promote prosperity or deflate the economy into unemployment almost at will. For this reason the banks are closely controlled in their credit policies by the Bank of England, which is itself influenced and controlled by the Treasury.
In February 1982 the commercial banks had made advances totaling over Rs. 248,0000 million in loans and overdrafts, Another Rs. 33,6000 million was invested in more permanent ways, in industrial and chimerical firms.
Simple and Sophisticated Views of Bank Lending Policy
The lending policy of the banks depends upon that simple idea mentioned earlier that some, if not most, of the funds people deposit in the bank are left idle. The early bankers observed that only about 8 percent of their customer’s funds were likely to be demanded in cash at any time.
They therefore made sure that they always had a reasonable ‘prudential reserve ratio.’ This means they kept a prudent amount of cash in reserve and could always repay depositors if they asked for cash in reserve and could always repay depositors if they asked for cash.
Since August 1981, this term has been revived, with the Bank of England discussing with each bank its ‘prudential reserve’ policy to ensure banks keep an adequate float of cash in hand.
The terms ‘cash ratio’ and ‘minimum reserve ratio’ are no longer used. We might think that if Rs. 7200 is lying around idle the bank might prudently lend to someone short of money, charging him interest on the loan. In fact, the bankers take a much more sophisticated view of what that Rs. 8000 means to them. Mr. A has given them Rs. 8000. They have in the bank. They therefore have enough cash to form the minimum reserve ratio of a total deposit of Rs. 8, 0000. Of course no one has actually deposited Rs. 8, 0000; Mr. A has deposited only Rs. 80000.
The bank can therefore now lend up to Rs. 72000 as a real deposit: they are unaware that it is borrowed money. This is where the banker’s statistics give him confidence. He knows that the garage proprietors will demand only 8 percent of their deposit.
It is most unlikely that they will demand as much as 10 percent, the amount kept in reserve. Meanwhile the bank is making a nice profit from the interest on Rs. 72000 it never really had.
We can now see what effect the creation of purchasing power by the banks has on the economy. Mr. B to buy a Rs. 72000 car and Mr. C to spend Rs. 720. In other words, and expenditure of Rs. 80,000 has been based on Rs. 8000 of savings. If the banks pursue such policies unchecked the people of this country will be permitted to live at a higher level than they are really entitled to, and problems will arise with our Balance of Payments.