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This unit introduces the students to the commercial banking as a bedrock of all 
financial institutions and medium through which monetary policy is transmitted 
to the public. This is because commercial bank is a retail bank with widest 
coverage in terms of customer and dealings. The unit equally explored the 
money creation activity of commercial bank as well as their financial intermediation functions.
At the end of this unit student should be able to;
i. Understand the role of deposit money bank in an economy. 
ii. Understand how commercial bank creates money.
iii. Understand the financial intermediation function of commercial bank.
iv. Explain the process of achieving monetary policy through commercial 

Commercial Banking

Commercial banks are the key institutional mechanism through which money 
performs it numerous functions in any economy. It is, therefore, important to 
examine the specific role of commercial banks in a given economy. This will 
serve to clarify the process of monetary management. The commercial bank is 
also known as deposit money bank because they are retail bank who accept 
deposit from all and sundry. Commercial banks are also known as fractional 
banking system because commercial banks create money and that a fraction of 
deposit is kept to meet the deposit liability. This fraction gives insight to the 
monetary authority on the base money
Commercial banks offer a variety of services to the individual, the company, the government and the community. These functions include; the acceptance of deposit of money and other valuables, lending money to customers including 
governments, serving as agent of monetary transactions to the customers; 
offering economic intelligence services and keeping customers' accounts.

Self Assessment Exercise
i. Explain the functions perform by deposit money bank. 
ii. What is commercial banking?
iii. Explain process involve in lending money to customer

Credit Creation in Modern Banking

One of the major disguising characteristics of commercial banks, among other financial institution, is that it can create money. This literally implies that it can increase the supply of money by granting loans or credit.
Historically, this practise can be traced to the early goldsmiths who learned that 
they could lend out part of the gold that has been deposited with them. This was 
possible since the entire gold deposit look alike and since gold is a homogenous 
commodity, one person's gold on deposit could be retrieved by the owner on the 
presentation of the receipt (certificate), but it did not have to be very same gold 
which have been deposited. Since not all the depositors were likely to demand 
their gold at the same time, the goldsmiths realized they could make fast money through prudent lending of a fraction of the gold for safe keeping. Let us now work through carefully how a Morden commercial bank creates money by an efficient of the early goldsmith's principle of fractional lending. The following assumption will enable us see without complications, how this process of money creations works:
a. We assume that there are 10 commercial banks in hypothetical economy named Bakare city. This assumption is to enable us deal with a realistic situation where there can be many banks in an economy.
b. All commercial banks in Bakare city are required to keep a certain percentage of deposit with them as cash. This is the cash. Specify to be reserve ratio which we shall specify to be 10%.
c. There is no leakage of currency either outside the economy or into non�bank savings, transaction purposes, etc.
d. Each commercial bank stands ready to grant loans to its eligible customers 
on request.
With the above assumption we are going to trace what happen when Alhaja 
Surukat Adewale, on her death, leaves the sum of #50,000 under her pillow for 
her granddaughter, Dalat. Table 5.5.1 shows the process of money creation that 
starts as Dalat removes this money from her grandmother's pillow for deposit in 
the commercial bank, which we will call the Bank of the Patriots (BOP).
Alternatively, credit creation could be calculated by using a formula related to 
that of sum to infinity of a series, which is given by Mc = A/R or A/1 - r
Taking the above situation into consideration: 
A = Initial deposit
R = Statutory Reserve Requirement. 
r = Excess Reserve
Mc = A/R = 50000/0.1 = 500,000.00
Mc = A/1 - r = 50,000/1- 0.9 = 500,000.00
Note: that excess reserve = 1 - R
Factors Affecting the Creation of Credit
In real life, the deposit expansion multiplier will not yield the theoretical number 
suggested above. Chances are high that the numbers will be less than that 
obtained by the reciprocal of the reserve ratio. In effect, therefore, the actual 
credit created will be less than the potential limit. Why would this be the case? 
The following are the main reasons.
Central Bank's Control via the Reserve Ratio: the reserve requirement ration 
is the fraction of every deposit that commercial bank is required by law through the central bank to keep in its vault in other to meet the deposit liabilities of the bank. However, the higher the reserve requirement ratio the less the banking 
system create money and vice versa.
Currency Drain From the Banking System: it is expected that all transaction 
should be done through the banking system through the use of cheque but some transaction are actually done outside the banking system, therefore the more transaction are done outside the banking system the less the system create money and vice versa.
Bank's unwillingness to lend: for optimum money multiplier the banking 
system must be willing to give loan, all things being equal.
Government Credit Guidelines: credit guidelines is the government control 
over disbursement of funds by banking system and this has a lot to do with 
money creation by the banking system.
Unwillingness on the part of the Public to Borrow: creation of money by the banking system is also limited by the fact that the public may not be willing to take loan, if the public has no or little interest in taking loan from the banking system, the system will not be able to create sufficient credit.

Self Assessment Exercise
i. What are the factor that limitate against credit creation.. 
Ii. List and explain the assumption of money multiplier.
iii. Is it possible for all transaction to be done through the banking system.?
iv. Differentiate between reserve requirement and excess reserves
v. calculate the money that would be created by the fractional banking system 
with initial deposit of #16,000 and a statutory reserve requirement of 25%

Financial Intermediation Function of Commercial bank.

Financial intermediation involves credit mobilization and disbursement activity
of the banking system. Commercial bank is a money market where short and 
medium loan are traded. Commercial banks do not print money they give as loan but rather mobilize deposit from customer (savers) and give same to another set 
of customers (lenders). The later is equally known as deficit spending unit while 
the former is known as surplus spending unit. The deficit spending unit (business 
men) has a lot to do with funds but not readily available to them while the surplus spending unit have the money but don't have any business idea at hand, 
the commercial bank stand as intermediary between these two groups and by so doing discharging financial intermediation function through mobilization of funds from SSU and disbursement of same to DSU. Now commercial banks stand between SSU and DSS at a price know as interest. The bank issue two types of rates, saving or deposit rate for savers, that is, owner of funds and charge lending rate from the user of funds (lenders). The deposit rate is much lower than the lending rate and the different between the two rates is the gain to the "intermediators", that is, the commercial banks. The diagram below explicitly shows the process of financial intermediation.

Self Assessment Exercise
i. Explain the process of financial intermediation. 
ii. Differentiate between DSU and SSU
iii. Define financial intermediation
iv. list the composition of both DSU and SSU
v. use suitable diagram to explain financial intermediation processes.


This unit examined the fractional banking system's money creation or credit
multiplier processes as well as other function performed by commercial bank, 
most especially the money creation activities of the banking system. The unit 
also discuss various limitations to money creation activities and finally conclude that as much as the banking system would have loved to create money some technical limitation are bound.


This unit discussed money creation activity of the fractional banking system
and the limiting factors to the activity, it also emphasised on other traditional 
function of the commercial banks. The unit examine the financial intermediation function of commercial bank and explain from mobilization of funds from the surplus spending unit to disbursement of funds to the deficit spending units on prices called the interest rates.

Marked Assignment

i. Explain the process of financial intermediation.
ii. Differentiate between DSU and SSU
iii. Define financial intermediation
iv. List the composition of both DSU and SSU
v. Use suitable diagram to explain financial intermediation processes 
vi. List and explain the assumption of money multiplier.
vii. Is it possible for all transaction to be done through the banking system?
viii. Differentiate between reserve requirement and excess reserves
ix. Calculate the money that would be created by the fractional banking system 
with initial deposit of #16,000 and a statutory reserve requirement of 25%.
x. Explain the functions perform by deposit money bank.
xi. What is commercial banking?
xii. Explain process involve in lending money to customer

References/Further Readings

Attah B.O, Bakare, T.A. & Daisi, O.R., (2011); Anatomy of Economics 
Principles, Q&A (Macroeconomics), Raamson Printing Press, Oke-Afa, Isolo, 
Lagos, Nigeria
Amacher, R and Ulbrich, H, (1986); Principles of Economics, South Western
Publications Co. Cincinnafi, Oliso
Bakare –Aremu T.A, (2013); Fundamental of Economics Principles
(Macroeconomics), Raamson Printing Press, Oke-Afa, Isolo, Lagos, Nigeria
Bakare I.A.O, Daisi, O.R., Jenrola, O.A., & Okunnu, M.A., (1999): Principles and Practice of Economics (Macro Approach), Raamson Printing Press, 
Mushin, Lagos, NigeriaDennis R. A. et-al; International Economics, Mcgraw 
Hill Irwin, 8th edition.
Familoni K.A, (1990); Development in Macroeconomics Policy, Concept
Publications, Lagos, Nigeria
Fashina E.O, (2000); Foundations of Economics Analysis (Macro Theories),
F.E.F International Company, Ikeja, Lagos, Nigeria
Jhingan M.L, (2010); Macroeconomics Theory, 12th edition, Vrinda
Publications (P) Ltd. Delhi, India
Jhingan M.L, (2010); International Economics, Vrinda Publications (P) Ltd. 
Delhi, India
Lipsey R.G, (1979); An Introduction to Positive Economics, Hayper & Raw, 
Umo J.U, (1986); Economics; An African Perspectives , Johnwest, Lagos Nigeria.
Gordon Robert J. (2009). Macroeconomics(Eleventh ed.). Boston: Pearson Addison Wesley. ISBN 9780321552075

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