The money you deposit in your bank’s savings account is actually the loan which you give to the bank, and the interest that the bank credits in your SB account is the interest the bank pays you for this loan you gave to the bank.

The bank lends back this money in the form of loans like personal loan, housing loan, etc to other customers in need at a higher interest than what they give you in your savings account. This is how banks make profit.

This is not the complete picture, but this is how it fundamentally works.

Now what if all the loans which the bank gives out is not paid back by those who took the loan? Then all your money in savings is gone as well, isn’t it? This is what happened in US subprime crisis causing banks to go bankrupt because of bad loans. Greedy banks lent out all the money which people had deposited as savings in the form of bad loans. The loans were not paid back, banks went bankrupt, people’s money was gone!

But in India we have a strict cash-reserve ratio (CRR) which the banks have to maintain with RBI, which means banks cannot give away all the savings money they have as loans and should always maintain good amount of cash balance with them. So there are little chances of Indian banks going bankrupt.

Additionally, banks also can borrow money from the Reserve Bank of India (RBI) at an interest rate, and can also deposit their money with the RBI at an interest rate. These interest rates are what we normally hear as repo and reverse-repo rates.

In other words, just like we are the customers of our banks, our banks are customers of the Reserve Bank of India. All the currency notes printed enter the market through the Reserve Bank of India into our banks and from there reach the market through us.

Reserve Bank gives loans to banks at an Interest rate. This is how money printed by the government enters the market via Reserve Bank of India in the form of loans given to banks. These banks then give loans to its customers at a higher interest and thus make profit.

RBI also takes money from banks and gives an interest on these deposits to banks. This is how RBI controls the money flow  in the market by giving loans to banks and taking deposits from banks. The interest at which RBI gives loans to banks is called the Repo rate and the interest which RBI pays to banks for their deposits with RBI is reverse repo rate.

If the Reserve Bank gives more interest to the money which the banks deposit with it, then the banks will prefer to keep their cash with the RBI instead of lending it to their customers as loans. This will tighten the outflow of money from the banks into the market, which has a negative impact on inflation or price rise. The less the money in the market, the less the money people have to spend, and the less chances of price rise because of decreased demand.

Similarly if the RBI gives very less interest to the money which the banks deposit with it, then the banks prefer to lend out their money as loans to their customers at a higher interest. This will cause more flow of money into the market. The more the money flow in the market, the more money people have to buy things, the more the purchasing power the more the demand for goods and services, and there will be rise in prices because of increased demand.

Here ends your simple crash course on how the banking system works.

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