BANKING: COMMERCIAL BANK AND

CENTRAL BANK

LEARNING OBJECTIVES
Commercial bank
Functions of commercial bank
Money creation or credit creation
Central bank
Functions of central bank
Central bank vs. commercial bank

INTRODUCTION
 A bank is a financial institution which accepts deposits,
pays interest on pre-defined rates, clears checks, makes
loans, and often acts as an intermediary in financial
transactions. It also provides other financial services to
its customers. In this chapter we shall learn about
commercial banks, credit creation by commercial
banks, central bank and its functions.
COMMERCIAL BANK
A commercial bank is a type of bank that provides
services such as accepting deposits, making business
loans, and offering basic investment products. A bank is

1
called a commercial bank if its primary motive is to
earn profit.
FOR EXAMPLE: State Bank of India, Punjab
National Bank, Axis Bank, ICICI Bank etc.

FUNCTIONS OF COMMERCIAL BANK

There are two types of functions – Primary Function
and Secondary Functions.

2
EXPLANATION: The functions of commercial banks
are discussed as follows:
 PRIMARY FUNCTIONS: These refer to the basic
functions of commercial banks that include the
following:
1. ACCEPTING DEPOSITS: This function implies that
commercial banks are mainly dependent on public
deposits.
There are three types of deposits, which are discussed
as follows:
 Demand Deposits: These refer to kind of deposits
that can be easily withdrawn by individuals
without any prior notice to the bank by simply
writing a check. Receiving these deposits is the
main function of commercial banks.
 Time Deposits: These refer to deposits that are for
certain period of time. Banks pay higher interest on
time deposits. These deposits can be withdrawn
only after a specific time period is completed by
providing a written notice to the bank.
 Saving Deposits: These deposits combine the
features of both demand deposits and fixed
deposits.

3
 DIFFERENCE BETWEEN DEMAND DEPOSIT AND
FIXED DEPOSIT
Basis Demand Deposits Fixed Deposits

Cheque facility These are These are non-

chequeable chequeable
deposits. deposits.
Interest payments They do not carry They carry a high
any interest. rate of interest.
Number of The depositors Depositor can
transactions can make any make two
number of transaction:
transactions for  Deposit of
deposits or money in
withdrawal of beginning
money.  Withdrawal of
money on
maturity

2. ADVANCING OF LOANS: It refers to one of the

important functions of commercial banks. The public
deposits are used by commercial banks for the
purpose of granting loans to individuals and
businesses. Commercial banks grant loans in the form
of overdraft, cash credit, and discounting bills of
exchange.

4
 SECONDARY FUNCTIONS: These refer to the
crucial functions of commercial banks. The
secondary functions can be classified under three
heads, namely:
1. AGENCY FUNCTIONS: These functions imply that
commercial banks act as agents of customers by
performing various functions, which are as follows:
 Collecting Checks: It refers to one of the important
functions of commercial banks. The banks collect
checks and bills of exchange on the behalf of their
customers through clearing house facilities
provided by the central bank.
 Collecting Income: Commercial banks collect
dividends, pension, salaries, rents, and interests on
investments on behalf of their customers. A credit
voucher is sent to customers for information when
any income is collected by the bank.
 Paying Expenses: It implies that commercial banks
make the payments of various obligations of
customers, such as telephone bills, insurance
premium, school fees, and rents. Similar to credit
voucher, a debit voucher is sent to customers for
information when expenses are paid by the bank.
2. GENERAL UTILITY FUNCTIONS: The general
utility functions provide useful operations to the
customers as well as to the banks.
5
 It include the following functions:
 Providing Locker Facilities: Commercial banks
provide locker facilities to its customers for safe
keeping of jewellery, shares, debentures, and other
valuable items. This minimizes the risk of loss due
to theft at homes.
 Dealing in Foreign Exchange: Commercial banks
help in providing foreign exchange to businessmen
dealing in exports and imports. However,
commercial banks need to take the permission of
the central bank for dealing in foreign exchange.
 Transferring Funds: It refers to transferring of
funds from one bank to another. Funds are
transferred by means of draft, telephonic transfer,
and electronic transfer.
3. OTHER FUNCTIONS: It include the following
functions:
 Creating money: It is one of the important
functions of commercial banks that help in
increasing money supply. This we will study later
in this chapter.
 Electronic Banking: It includes services, such as
debit cards, credit cards, and Internet banking.

6
CREDIT CREATION BY COMMERCIAL BANKS
A commercial bank is a dealer of credit. It creates
money based on cash deposits. Further, it issues new
money through its loan operations and creates credit or
expands the monetary base of a country.
Let’s understand credit creation through an example.
ASSUMPTIONS:
 There is multiple banking system in the economy
 Initial deposit is of Rs.1000
 Cash reserve ratio (Fixed percentage of primary
deposit which commercial bank has to keep in the
form of cash with RBI) is 10%
EXPLANATION:
Initial Bank Primary CRR Loan
deposit deposit
1000 HDFC 1000 100 900
ICICI 900 90 810
YES 810 81 729
- - - -
TOTAL 10,000 1000 9000
Total money creation = Initial Deposit * 1/CRR
=1000 * 1/10
Total money creation =10,000

7
TABLE SHOWS:
 Person A deposits Rs.1000 in HDFC Bank. The
amount becomes the primary deposit of HDFC Bank.
The bank keeps as CRR Rs.100 and advances loan of
Rs.900 to Person B.
 Person B makes payment to Person C and this Person
C deposits Rs.900in his account in ICICI Bank.
 Now Rs.900 becomes the primary deposit of ICICI
Bank and the bank keeps 10% as CRR i.e. Rs.90 and
advances loan of Rs.810 to Person D.
 This process of advancing loan goes on till the time
balance falls to zero.
 We therefore see, on the basis of initial deposit of
Rs.1000, a loan of Rs.9000 is being created in the
economy