Lecture no: 07 Topics: Central Bank Key wor me 'Y Words: 2 St money market, foreign exchange, bank rate, stability, reserve rate, interest Tate, prime rate, Creating, guardian, representative Definition Central bank is the guardian, director and controller of all the banks of the country. Central bank is the life and soul of the entire banking system. Different economic scholars and banking researchers have defined central bank differently at various times. Some noteworthy definitions are given below, “A bank which deals chiefly with other banks in holding the banking reserve of its country or district and normally Government agencies or Govt. related agencies and operated in the broad public interest.”—Dictionary of Banking and Finance Functions of Central Bank 1. General Functions © Issuing notes and Currencies Acting as the Guardian of Money Market Controlling Credit Controlling Foreign Exchange Maintaining price stability | Developing the Banking system of the country Mairtaining Foreign Exchange Reserve Creating employment opportunity Maintaining Gold Standard Sources of Credit Maintain Government Fund Maintain Government accounts Handle Government Transaction Purchase and Sale of Foreign Currencies Advisor Revenue Collection Representative of Government 2. Functions as a Banker of Government Enlistment of Bank New Branches Lender of the Last Resort Controlling the function of Commercial Banks Examining the Books of Accounts __ Advisor Functions as a Banker of Other Banks4 Agricultural Development 1 Functionasa . eee, Industrial Development Development Bank : Developing Foreign Trade ® Developing Cooperative Banks _ io le ke Work Functions e Research i a ¢ Supply of information e Transfer of Money Ensuring Use o0f Loan Write short notes on: 1, What do you mean by Central Bank? What is the main objective of Central Bank? Who perform the function of issuing notes? 2. 3. Define money market. 4. Define capital market. 5. What do you mean by inflation? 6. What do you mean by deflation? 7. 8. Who is the “Lender of the Last Resort”? 9. Define Clearing House. 10. Who is the guardian of all Commercial Bank in our country?CREATION OF CREDIT Creation of credit has become a major function of commercial banks wit habit among the people. In their desire to minimise the hu.ding of idle cish with them, th b unwittingly increase the total amount of money i» circulation in the countr’ However, ‘td vs mean that they increase the legal tender currency in the coun. It simy oe ‘ iply means increxse in creatior of deposits with the bank which can help in further credit creation. As a matter of fact on acquit growing popularity of the credit instruments, particularly the cheques, the banks are in a position to lend more than what their resources apparently permit. This is possible because of the fact that while granting a loan, the bank docs not give cash to the borrower but simply credits his account with the amount of loan and authorises the borrower to withdraw money from his account to the extent of the toan given. The borrower may issue cheques in favour of his creditors for making payments which in turn again are deposited by the creditors in their respective bank accounts. In this process the transaction between the borrower and the creditors are settled without any transfer of legal tender money but simply through cheques. h the rapid growth in banking From the above discussion it can be concluded that the banks have two types of deposits : \ (i) Primary Deposits. These consist of cash deposited by the people with the banks in different deposit accounts—savings, fixed or current, as the case may be. The initiative of creation of these deposits is taken by the depositors thomselves. (ii) Derivative Deposits. These consist of deposits created by the banks in the process of eri ig credit. The loans sanctioned and credited to the accounts of the borrowers create new deposits. + Thus, itis true to say “deposits create loans and loans create deposits”. “The creation of credit is mainly cortcemed with De‘ativé Deposits as e-plained below in the mechanism of credit creation. \-Mechanism of Credit Creation The mechanism of credit creation can be derstood with the help of the following example nity which is highly banking minded settling all transactions total legal tender money in circulation is Rs. 10,000 and 5 of its Let us take the case of a'commt" through cheques. Let us als) assume that the there only one bank, The bank likes to keep a 20% cash reserve to meet the requiren depositors who may turn up to withdraw cash at the bank's counter, The Balance Sheet of th appear as follows : BALANCE SHEET a — ee & Liabilities . Assets =b ceding nt bak has to Keep only 20% as cash reser it advances Rs. 800 1 BarTONSTS "| c 8 their accounts with it. The Balance Sheet will now appear as follows BALANCE SHEET Liabilities erage ‘Assets Depts) > +} —__ 8 _ Primary 10.000 | Cash in and Derivative Advances 8,000 ‘The total deposits with the bank are now "s. 18,000. Since the bank has to keep only 20% as cash reserve, it can advance further Rs. 6,400 (ie., RS. 8,00 Rs. 1,600) by crediting the accouits of the borrowers, The Balance Sheet will now be as follows : BALANCE SHEET Liabilities Rs. Assets Deposits : eee Primary 10,000 |} Cash in band Derivative (8,000 + 6,400) 14,400 || Advances 400 a ‘The bank has thus created a further deposit of Rs. 14,400 with a primary deposit of Rs. 10,000. The additional deposit of Rs. 14,400 is known as derivative deposit. The depositors have a right (0 issue cheques against their deposits with the bank, hence the purchasing power of the depositors increases to the same extent. This means whenever a loan is granted to a customer, a deposit is created. As such it has rightly been said, “every loan creates a deposit and evéry deposit creates a loan” ‘The term ‘bank credit’ implies loans and advances by banks. The term ‘credit creation’ refers to “multiplication of loans and advances” since every bank's loan creates an equivalent deposit, credit creation by banks, means multiplication of bank deposits. 1 other words the capacity of the banks to + expand deposits by increasing their loans and advances is known as credit creation. ————S “The capacity of the banks to create credit isthe reverse of cash deposit ratio, For instance in the above example the bank can create total deposits to the extent of Rs, 50,000 (i.e., Rs. 10,000 x 100/20). The formula for deposit creation can therefore to put a follows (aM)= Mxk . where (4M) = Total Deposit Creation ‘AM = Cash in hand available with bank k= Deposit Multiplier The deposit multiplier (k) can be ascertained as follows where. k= Deposit multiplier Cash reserve ratio For instance in the example the deposit multip.er comes toee fs STEEL ea Since 1 crdiing ine bank {8s 10 Keep only 208 as cash reserve, it advances Rs, 8000 to borrowers by *ounls with i. The Balance Sheet will now appear as follows BALANCE SHEET || Cash in hand Advances. ative The total deposits with the b; i 3 nk are now "s, 18,000. Sirce the bank has to keep only 20% cash reserve, it can advance further Rs 8 ) by eeig te aeons ; 6,400 (i.e, Rs. 8,009 Rs. 1,600) ing the account the borowers, The Balance Sheet wll no bea fallous Yee the accounts of BALANCE SHEET fi Liabitties {eee aeERTEEEECT acegee ECCOEEECE Deposits See ianniae Primary 10,000 |) Cash in hand Derivative (8,000 + 6,400) | 14400 | Advances 24,400 ‘The bank has thus created a further deposit of Rs. 14400 with a primary deposit of Rs. 10,000, The additional deposit of Rs. 14,400 is known as derivative deposit. The depositors have 2 right to 'ssue cheques against their deposits with the bank, hence the purchasing power of the depositors increases to the same extent. This means whenever a foan is granted to a customer, a deposit is created As such it has rightly been said, “every loan creates a deposit and every deposit creates a loan” ‘The term ‘bank credit’ implies loans and advances by banks. The term ‘credit creation’ refers to “multiplication of loans and advances” since every bank's loar creates an equivalent deposit, credit creation by banks, means multiplication of bank deposits. In other words the capacity of the banks to + expand deposits by increasing their'loans and advances is known as credit creation. The capacity of the banks to create credit is the reverse of cash deposit ratio. For instance in the above example the bank can create otal deposits othe extent of RS, 50,000 (ie, Rs, 10,000 x 100/20) The formula for deposit creation can therefore to putas follows (AM) = AM xk , where (AM)= Total Deposit Creation AM = Cash in hand available with bank k= Deposit Multiplier “The deposit multiplier (k) can be ascertained as follows: . o 1 where. k= Deposit multiplier r= Cash reserve ratio * "coy instance in the example the deposit multip..er comes to:ie r = oe 5 The amount of total deposit created can be ascertained as follows (AM)= 4Mxk = 10,000 5 = Rs. 50,000 Continuing the above example, the balance sheet of the bank at the level of maximum deposit creation will be as follows BALANCE SHEET _ Bs. | Assets. Bs. Deposits: | Primary 10,000 || Cash in hand 10,000 Derivative 40,000 || Advances 30,000 ||’ Creation of credit when there is more than one bank 2 So far we have stud.ed credit creation when there is only one bank. However in practice there are more than one bank serving the community. In such a gase also the total credit/deposit creation of the, banking sysiem will remain unaffected. There will be siqply transfer of deposit from one bank to , another. For instance there are two banks X and Y. A is the customer of X Bank while B is the customer of ¥ Bank. A draws a cheque in favour of B which B deposits with his bank. In such a case there will ,be a transfer of funds from X Bank to ¥ Bank without in any way affecting the total deposits of the banking system, Credit contraction : In the preceding pagas we have explained the multiplier effects on credit creation of increase in deposits of commercial banks. On the same pattern the decrease in deposits has also a multiplier effec: on credit creation capacity of commercial banks. For the sake of convenience let us presume that there are three banks A, B and C, each having a cash balance of Rs. 1,000 and Advances and Investments of Rs. 4,000. The total deposits of each bank being Rs. 5,000. Each bank is required to have a cash reserve ratio of 20%. Xa depositor withdraws Rs. 100 from A Bank. The position of the bank will be as follows : i BALANCE SHEET OF A BANK : Liabilities Bs, Assets | & Dei 4,900 || Cash Balance : 900 || Advances | 400 4,900 4,90 |Lecture no: 08 -99 Topics: Central Bank | Key words: Quantitative, Qualitative, rationing, moral, suasion, open market, reser’ | tate, interest rate, prime rate, variation. Methods of credit control by central bank aa Methods of credit control followed by the central bank may chiefly be divided into two Parts considering their characteristics. These are: > Quantitative method and > Qualitative method Quantitative Methods: e . In this method the central bank controls the power of commercial banks to extend credit. Central bank increases or decreases as per necessity, the power of commercial banks to sive credit. One of the big demerits of these methods is that it does not consider the Practical importance of credit. As a result credits in important and comparatively less important sectors are equally controlled. 1. Bank Rate Poli By increasing or decreasing bank rate central bank controls credit. If bank rate is reduced * the power of commercial banks to give credit is enhanced and the supply of money in the market is increases. Again if the bank rate is increased the power of commercial banks to extent credit is reduced and supply of money in the market decreases. 2. Open Market Operation: The process of buying and selling securities and credit instruments from open market by the central bank with a view to controlling credit is called open market operation, If the central bank wants to reduce the supply of money it sales credit instruments in the open market and purchases securities from the market in order to increase the supply of money. 3. Reserve Rate Variation Policy: By increasing or decreasing this rate or ratio of this deposit the central bank increases or decreases the capability of commercial banks to extent credit. Qualitative Methods The regulation of credit control for specific purpose or branches of economic activity is termed as selective or quantitative credit control. 1. Rationing policy Basically it is a specialization process. It is applied to controlling credit in special sectors. Commercial banks ‘are given instruction to give credit considering the objective and nature of credit: In this method, for a particular objective a highest limit of credit is fixed for a particular sector for a fixed time in order to encourage or discourage that sector.2. Moral Suasion It is the objective of this method to make aware of credit control by eed pores In this method the Central Bank informs the commercial banks about the objective of the credit control and requests them to achieve that objective. 3, Direct action: The Central Bank generally applies this method to those commercial banks, which seriously violate the orders and instructions of the central bank. In this method the central bank increases the rate of discounting bills of that particular bank or the central bank imposes higher rate of interest on the credit of that bank. 4, Publicity: The real picture of money market is placed before all banks through weekly, monthly and yearly publications of the central bank and they are encouraged to control credit. Relationship between Central Bank and Scheduled Banks There exists a close relationship between the Central Bank and Scheduled banks. Which are given below: 1. Guardian: Central Bank is the guardian of commercial banks, which have to follow all rules and regulations set by the CB. . Statutory Reserve: Commercial banks have to reserve a portion of its deposit in Central Bank, which bring these two banks more closely. nv . Banker of all Banks: Central Bank work as a banker of all other banks, and thus, helps to develop a good relationship between them. w 4, Membership Facilities: Commercial banks enjoy the facilities of borrowing, discounting of bills, re-financing, etc. from the Central Bank. 5. Lender of the Last Resort: Commercial banks, as the last option, take loans from the Central Bank in case of any financial crisis. Therefore, the relationship between CB and commercial banks is called Banker-Customer Relation. 6. Co-partner: Central Bank and commercial banks work as family co-partners CB implements economic plans and policies for the assistance of commercial banks. 7. Statement of Performance: A close relationship keeps on developing between the Central Bank and commercial banks, as banks have to send statement of all their banking activities to the Central Bank once in a week. 8. Order Carrier: Commercial banks are the follower of all the rules and regulation of the Central Bank. 9. Liquidity: To ensure the liquidities, commercial banks have to keep a certain amount of their deposits for Central Bank as reserve. This is an indicator of the relationship between the CB and the commercial banks.10. Informati market of ho; * Central Bank supplies all information regarding the money Process deepen oad, as well as of the economy to commercial banks. hiss Cooperaten ce isting relationship between them Central Bank and commercial banks maintain a cooperative relationships tween i anal them. Therefore, question of rivalry and competitive do not arise between Commercial banks, 12. Clearing House: Central Bank f transactions among the commercial banks as the cles: settles all kinds of tran: ie inghouse of commercial banks. Differences between ppiere central bank and commercial Banks ‘ormation tis established by a [Such bank is established with the approval of pecial law or ordinance}the govt. on the basis of existing company law inder private of public ownership. Ownership [Generally this bank is in most ofthe cases, itis established under tablished under govt. [private ownership. But sometimes it is wnership but sstablished by the order of govt. policy under lsometimes it is established under [private ownership Ibjective lIts basic objective is not|lts basic objective is to gain profit. (0 give profit but grater er welfare, ‘0. of banks There is only one [There is more than one commercial bank in a central bank ina ountry. country. (Control [It is totally control and [It is controlled and run by the owner or frun by the government. shareholders Govt. ere is direct govt. [There is indirect influence of the government influence linfluence over it. jover it through central bank. |Agent It works as an agent of [Sometimes it works as an agent of the client. the state. [State in money It is the organizer, [It is only a member of the money market under market ‘ontroller and director control of the central bank, lof money market.Competition [Credit control {Clearing house Lender of the onship with the govt lation i i F ati Relation with [There is direct relation [There is no direct el he govt. th the govt. it does not engage in thave on competitor ithin the count \Generally it does not ranches ave any foreign ranch. (Central bank has the it controls credit by increasing or decreasi surrency supply. \ouse it settles ransaction among ifferent banks. jmonetary crisis of the lgovt. or commercial yanks. lass 1 bills of commercial banks. ‘ustomer ‘he govt. is the main sustomer of the central [he general people and the business bank. Commercial yanks are also treated. sustomer as they take |any competition and it wuthority to issue notes. JAs the head of clearing litacts as the lender of last resorts. the last resort during IBut there is relation with the govt. through central bank. Iris engaged In tough compeiition and survives through competition. lit may have foreign branches ‘ommercial banks only help the central bank in| this respect. ing} 's the members of clearing house they settle transactions among themselves through the {intermediary of the central bank. \t the time of monetary crisis they take shelter \f the central bank. [Discounting [Central bank has the r Ine commercial bank cannot discount bills of fauthority fauthority to discount janother commercial bank. But they have authority to discount bills of clients. ¢ customers of commercial banks are chiefly rganization. as lloan from it. Write short notes on: What is Quantitative method of credit control? What is Qualitative method of credit control? What is open market operation? 1 WEN What is bank rate policy? What is reserve rate variation policy?Lecture no: 11 Topics: Commercial Bank yan, cash credit, overdraft, profitability, function, proper | Key words: | function, ut Definition hee * A Commercial Bank is essentially meant for providing short term credit to tr and industry. Commercial Bank is called the lender of borrowed money. The main Purpose of these banks is to earn profit. It collects the surplus money of people and lends that money to the deficit group. By transferring the deposited money between two groups, Commercial Bank earns profit. * “The figancial institution which earns profit through acceptance of deposit, extending credit, issuing notes and checks, receiving and paying interest is called commercial Bank.” “Bank is a real financial insti People and lend it to other group of people.” Bar Bari & Black tution which receives deposit from a group of Objectives of Commercial Bank: * Profit + Media of Exchange * Capital Formation * Public Welfare + Help in Planning * Employment Creation + Savings Propensity + Economic Stability * Development of Industry and Commerce * Development of Standard of Living Functions of Commercial Bank 1) Primary Function of Commercial Bank: a) Accepting of Deposit b) Lending of money ~- Loan - Cash Credit - Overdraft - Discounting and Purchasing of Bill 2) Secondary Function of Commercial Bank a) Agency Function b) General Utility FunctionFUNCTIONS OR SERVICES OF COMMERCIAL BANKS The functions of the commercial banks are now we and diverse “ey have assumed great significance in the role of an agent for economic renaissance and social tr. isformation because of their vital role in mobilisation of resources as well as their deployment for meeting the said objectives. They are no longer considered as institutions only for affluent sections of the population. They have acquired broad base and have emerged as effective catalytic agents of social economic change. In order to understand better the functions of commercial banks. It will be better to study them under the following two categories : og Primary Functions of Commercial Banks. (Ly Secondary Functions of Commercial Banks. I. Primary Functions/Services of Commercial Banks The primary functions of commercial banks are : (i) Accepting of deposits, and (ii) Lending of money. Accepting of Deposits. Deposits are an important source of a bank’s funds. They can broadly be classified jpto three categories. . Lo Deposits. These deposits are of small amounts and are accepted by banks to encourage persons of sinall means to make savings. Frequent withdrawals are not allowed. MO Fsel Deposits. These deposits are made with the banks for fixed periods specified in advance. They are also known as term deposits. Current Deposits. These deposits are repayable on demand. The banks undertake the obligation of paying all cheques drawn against these deposits by the customers till they have adequate funds of the customer. The banks usually do not pay any interest in respect of such deposits. Thess Lending of Money. A major portion of the deposits received by a bank is lent by it. This is also he major source of a bank’s income. However, lending money is not without risk and, therefore, aprecautions in this process. The lending may be in any of the following “Bape must ake BOPer PR r forms race made with or without security. It is given for a fixed period at So an is usually credited to the credit of the customer's account ae from there as pe is requirements. The loan may be secured or unsecured ' went by which a banker allows his customer to borrow money who may vi fy Cash Credit Misa amr in Limit against security 0 upto certain limit agains! $° nt whereby a customer has been allowed temporarily to ant is without any security . SEF Overdraft. 1s 80 ATEN werdfaw his current account : : a een and purchasing of bills. Time bills are discounted while demand bills are oth the cases the banks credit the accounts of their customers by the int or commission charged for such discounting or purchasing of the purchased by the banks. In amount of bills less any discou bills. ‘Thus, commercial banks render a unique service by tapping savings from a wide spectrum of people and lending to those who really need and use them for various productive purposes. They play an active and not a pasive role inthe economic development of the country. II, Secondary Functions/Services of Commercial Banks! ‘These functions or services can be classified into the following two categories (@) Agency Service. In many vases the commercial banks act as the agents of their customers. As agents they provide the following services : : Collection of drafts, bills, cheques, dividend etc. on behalf of customers ‘Execution of standing orders of the customers viz. payment of subscription, rent, bills, romissery notes, insurance premium etc. (i Conducting stock exchange iransactions i.e, purchasing and selling of securities for the Somers. Wh acing as a correspondent or representative of customers, other banks and financial conporations. - (v) Functioning as an executor, trustee or administrator of an estate of a customer. (vi) Preparation of income tax returns; claiming of tax refunds and checking of assessments on behalf ofthe customers. (b) General Utility Services. Commercial banks provide a variety of general utilify services viz ise fetes of rei. tavelescenuesbcptng CADE To ste custody. acing aa eres = to the respectability and financial standing of the customers, providing specialised advisory services to ‘customers, issue of credit cards, providing of information through regular bulletins about general trade and economic conditions both inside and outside the country etc. ce E Fi With the opening up of.the insurance sector, banks can now take up insurance business, In the Ssion paper issued by RBI in 1999, it was stated that insurance comes within the scope of universal banking. The term universal banking refers to the combination of commercial banking and investment banking. In other words universal banks refer to those banks that offer a wide range of financial services, beyond Commercial banking and investment bankings such as insurance. However, ae the guidelines issued by the Reserve Bank of India, banks are not allowed to conduct insurance ee bed Cannot also set up separately subsidiary companies for this purpose they P joint venture companies for insurance as per Governmenv/Insurance |. For more details please refer tothe chapters on ‘Relationship bet + and * Services of Banker’ given ater inthe book. pe peavey Beaker and Customer: snd “Anclacy