Commercial banks make money by earning interest on money that was loaned to borrowers. In many cases, the loan becomes a Non-Performing Asset (NPA) for the bank. There are instances where the borrower could go bankrupt, leaving the bank with a loss. In such situations, it becomes critical for commercial banks to assess the borrower's ability to repay the loan in a timely manner.
Now, if we look at this scenario closely, we realize that every loan is funded by the money deposited by other customers. Thus, the commercial bank owes interest to the depositor for the money deposited for a time period. This is usually the interest on the depositor's money that is credited by the banks on a quarterly basis. The bank also profits if it charges the borrower more interest and pays a low interest to the depositor.
In this chapter, we will derive...
