IGCSE Economics 0455: How Commercial Banks Act as Financial Intermediaries

Amara deposits $5000 into a savings account at Silverbrook Bank, which pays her 2% interest per year on this balance. Silverbrook Bank lends $5000 to Tomasz, a local baker who wants to buy a new oven, charging him 7% interest per year on the loan. Amara also uses a debit card issued by Silverbrook Bank to pay her monthly rent electronically, without needing to withdraw or carry cash.

(a) Describe, step by step, the process by which Silverbrook Bank turns the money Amara deposits into a loan that Tomasz can use to buy his oven. [3]

(b) Calculate the interest Silverbrook Bank pays Amara in one year and the interest it receives from Tomasz in one year, and hence calculate the bank's profit on this pair of transactions in one year. [2]

(c) Identify and explain one service, other than accepting deposits and making loans, that Silverbrook Bank provides to Amara in this scenario. [2]

Part (a): How Silverbrook Bank turns Amara’s deposit into Tomasz’s loan

Amara’s $5000 does not sit untouched in a vault, and it is not physically handed over to Tomasz either. Instead, Silverbrook Bank acts as a financial intermediary, standing between savers like Amara and borrowers like Tomasz:

Amara’s $5000 deposit joins a much larger pool of money deposited by many other savers at Silverbrook Bank.
The bank keeps back only a small portion of this pooled money in reserve, to make sure it can meet everyday withdrawals from its depositors.
The bank lends out most of the pooled deposits, an amount equal to Amara’s $5000 among it, to borrowers it judges creditworthy, such as Tomasz, who wants to buy a new oven for his bakery.
Tomasz receives the $5000 loan and repays it to the bank over time, together with interest, while Amara’s own $5000 balance remains available to her, along with the interest the bank pays her for keeping it deposited.

In this way, the bank channels money from people who want to save into loans for people who want to borrow, without either Amara or Tomasz needing to find and negotiate with each other directly.

Part (b): Calculating the bank’s interest rate spread

Interest paid to Amara on her $5000 deposit at 2% per year: $5000 \times 0.02 = 100$

This is $100 paid to Amara in the first year.

Interest received from Tomasz on his $5000 loan at 7% per year: $5000 \times 0.07 = 350$

This is $350 received from Tomasz in the first year.

The bank’s profit on this pair of transactions is the difference between what it receives from lending and what it pays out to savers: $350 - 100 = 250$

So Silverbrook Bank makes a profit of $250 in the first year from this pair of transactions.

Part (c): Another service Silverbrook Bank provides

Besides accepting Amara’s deposit and lending to Tomasz, Silverbrook Bank also gives Amara a debit card, which she uses to pay her monthly rent electronically. This is a payment service: it lets Amara transfer money directly from her account to pay for goods, services or bills without needing to withdraw, carry or count out physical cash. This kind of service is important to households because it makes everyday transactions faster, safer and more convenient, while still keeping their money held securely with the bank until it is actually spent.

Final answers

(a) The bank pools Amara’s deposit with other savers’ deposits, keeps back only a small reserve, and lends the rest, including an amount equal to Amara’s $5000, to borrowers such as Tomasz, who repays the loan with interest.
(b) Interest paid to Amara = $100; interest received from Tomasz = $350; the bank’s profit = $250.
(c) The debit card Silverbrook Bank issues Amara is a payment service, letting her make electronic payments such as rent without using cash.