BANKING

Central Bank (Reserve Bank of India)

It is the apex bank that controls the entire banking system of the country. It is the sole agency of
note issuing in a country. It serves as a banker to the government and controls the supply of
money in the country.

Functions of the central bank

1. Bank of issuing notes – Central bank of a country has the exclusive right of issuing
notes. This is called currency authority function of the central bank.
2. Banker to the government: Central bank is a banker, agent and financial advisor to the
government. As a banker to the government, it buys and sells securities on behalf of the
government. As an advisor to the government, it helps the government in framing
policies to regulate the money market.
3. Lender of the last resort- We know, commercial banks create liabilities, many times
more than their cash reserves. This arrangement works fine so long as people have
confidence in the banking systems of the country, and they live up to banking
expectations that all depositors do not show up at a single point of time to withdraw their
deposits, however, there may be occasions when a bank suffers the crises of confidence,
and people go crazy to withdraw their deposits. The depositors are griped by the fear that
the bank may run out its cash reserves. It is in such a situation that the central bank acts
as a lender of last resort. Not only that it offers loans to the bank in crises, but also stands
as a guarantor of saving its solvency, it is owing to RBI’s guarantee that the banks are
able to battle the crises of confidence.
4. Bankers Bank and Supervisory Role-The central bank is the bankers bank and also plays
a supervisory role. As a bankers bank it has almost the same relation with other banks in
the country or the commercial bank has it with its consumers. It accepts deposits from the
commercial bank and offers them loan. The rate at which the central bank offers loans to
the commercial banks is called the Reporate , it is also called banks policy rate, the rate
at which the commercial banks are allowed to keep their surplus funds with the RBI is
called Reserve Reporate .
5. Custodian of Foreign exchange - Central bank is the custodian of nation’s foreign
exchange reserves. The central bank not only maintains foreign exchange reserves but
also exercises managed floating to ensure stability of exchange rate in the international
money market.

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 Managed floating refers to the sale and purchase of foreign exchange with a view to
achieving stability of exchange rate for the domestic currency.
6. Clearing house functions – Central bank also performs the functions of a clearing house.
i.e. it provide guidance to banks related to inter banking transactions.
7. Control of Credit- The most important functions of the central bank , is to control the
supply of credit in the economy. It implies increase or decrease in the supply of money
by regulating the ‘creation of credit’ by the commercial banks.

Difference Between Central and Commercial Bank

S.No Central Bank
1 It is an apex bank it is a bank of all the
banks
2 It focus on stability and growth
3 Central bank controls the creations of
credit through CRR and SLR
4 Central bank accepts deposits and provide
loans to other banks
5 It is the custodian of foreign reserves of
the country
6 It is note issuing authority
7 It is a monitoring authority of the
country’s entire banking system
8 It deals with government
9 It functions with co-ordination of finance
ministerial other economic minister
Commercial Bank
It function under the control of the central
bank
It focus on profit maximization
A commercial bank contributor to the
supply of money through credit creation
It accept deposits and provide loan to
general public
The commercial bank is not a custodian of
foreign exchange reserve.
It is not a note issuing authority
It is simply an element of the banking
system
It deals with general public
It function with accordance , producers ,
rules which are laid down by central bank

Q. How does the central bank controls the money supply?

Or

Quantitative and Qualitative instruments of money supply?

Central Bank

Quantitative Measures Qualitative Measures

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I Quantitative Instruments of Monetary Policy

These are those instruments of monetary policy which affects overall supply of money/ credit in
the economy. These instruments do not direct or restrict the flows of credit to some specific
sectors of the economy. These instruments are as under:-

(a) Repo Rate – [Current rate is 8%]

The repo rate refers to the rate at which the central bank gives short term loans to the
commercial bank. The increase or decrease in repo rate is often followed by increase or
decrease in the market rate of interest. Accordingly the cost of credit (also called the cost of
capital ) changes in the market .During inflation, the cost of capital is increased by increasing
the repo rate and vice – versa.

(b) Open Market Operations – It refers to sale and purchase of securities in the open market
by the central bank. By selling the securities the central bank soaks liquidity (cash) from
the economy. And, by buying the securities, the central bank releases liquidity. When
liquidity is soaked, cash reserves of the commercial banks are squeezed. Implying a cut in
their credit creation capacity. On the other hand, when liquidity is released cash reserves
of the banks tends to rise. Implying a rise in credit creation capacity of the commercial
banks. We know any change in cash reserves of the banks cause a multiple change in the
supply of money in the economy.

II Qualitative Instruments of Monetary Policy

There instruments direct or restrict the flows of credit to specified areas of economic activities
there are broadly classified as under:

1. Margin Requirement – The margin requirement of loan refers to difference between the
current value of the security offered for loan and the value of loan granted. In case, the
flows of credit is to be restricted for certain business activities in the economy the margin

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 requirement of loan is raised. The margin requirement is lowered in case the flow of
credit is to be increased.
2. Rationing of credit – It refers to fixation of credit quotes for different business activities,
the commercial bank cannot exceed the quota limit while granting loan.
3. Moral – Suasion
Sometimes, the central bank markes the member banks agree through persuasion or
pressure to follows it directives on the flows of credit. The member banks generally do
not ignore the advice of the central bank .The banks are advised to restrict the flows of
credit during inflation, and be liberal in lending during deflation.

Commercial – Banking:-
A commercial is that financial in institution which accepts deposits from the people and offers
loans for the purpose of consumption or investment.

Definition – Banking:
According to Indian Banking companies Act, “banking company is one which transacts the
business of banking which means the accepting (for the purpose of lending or investment) of
deposits of money from the public repayable on demand or otherwise and withdrawable by
cheque, draft order or otherwise.”

Primary Functions of Commercial Banks:

Commercial banks performs two primary functions,

1) Accepting – Deposit
2) Advancing – Loan

(1) Accepting Deposits

A bank accepts deposits from the public. People can deposit their cash balances as : chequeable
deposits or non-chequeable deposits. Chequeable deposits are those against which cheques can
be issued(and therefore money can be withdrawn) any time.

Non- chequeable deposit are those against which cheques cannot be issued(and therefore money
cannot be withdrawn) any time. Instead, money in these deposits is kept as reserve with the bank
for some fixed period of time. Accordingly, these deposits are also called fixed deposits.

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(2). Advancing Loans:-

Another primary function of the commercial banks is to advance loans. Banks advance loans
mostly for productive purposes, against some collateral (security offered by the borrower for
loans). As a source of funds for investment (or even for purpose of consumption), bank play the
role of money creators or credit creators.

Financial Institutions
Financial Institutions is not banking institutions if it does not perform the two primary functions:
(i)accepting chequeable deposit and (ii) making advances or offering loans.

Thus

LIC is a financial Institutions but not a bank, as it offers loans but does not accept chequeable
depositor from the people.

Post –offices are also not banks, even though they accept deposits from the people. Because
they do not offer loans.

Money Creation by Commercial Banks

The previous chapter indicates that there are three sources of money supply in india: (i) the
central bank (RBI) which is the central authority of note- issuing, (ii) the central government
which issue coins, and (iii) the commercial banks, which create money on the basis of their cash
reserves. The present chapter focuses on the creation of money by the commercial banks. Two
points need to be noted at the outset: (i) the commercial banks do not have the authority of
issuing notes or coins, and (ii) cash reserves of the commercial banks are not treated as a
component of money supply. Simply because, cash held by the suppliers of money (RBI ,
Government and Commercial Banks) is never treated as a component of money supply.

Process of money creation by commercial bank:

Note the following observations carefully to understand how cash reserves of the commercial
banks are the basis of money creation:

1. Let us assume that all banks in the economy receive cash deposits of Rs. 10,000. These
are demand deposits of the people. The depositors can withdraw their money on demand,
simply by writing cheques. Therefore, these are also called chequeable deposits. These
deposits are liability of the banks.

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2. On the basis of their historical experience the banks realize that all the depositors never
show up at a single point of time to withdraw their cash deposits .Let us assume that the
banks find if safe to keep with them cash reserves only 10% of the demand deposits [=
10
* 10,000 = Rs. 1,000]. Thus, by keeping cash reserves of Rs. 1000 the banks can
100
handle the financial liability of Rs. 10,000. The necessary cash reserves which the banks
need to hold are called ‘Required cash reserves’ or ‘minimum cash reserves’. Now the
picture is like this:

Total Cash Reserves/

Demand Deposits with the banks = Rs. 10,000
Required Cash Reserves = Rs. 1,000
Excess cash reserves (briefly called excess reserves) with the banks = Rs. 10,000 – Rs.
1,000 = Rs. 9,000.

3. The bank can safely loan out the 9,000 Rs/- and earn interest income. But, the banks
never loan out in cash. Instead, an account is opened in the name of the borrower and
the loan amount is reflected or a credit item in the account. Thus, the bank continues to
hold Rs. 10,000 even when Rs 9,000 has been loaned out. By loading out Rs. 9,000, the
banks have only increased their financial liability by an amount of Rs. 9,000. So that,
their total financial liability now = Rs. 10,000 + Rs. 9,000 = Rs. 19,000. Ten thousand are
initial deposits of the people, called primary deposits. Nine thousand (credited in the
accounts by way of loans) are known as Secondary Deposits. Both are demand deposits,
as these can be withdrawn by writing cheques.

4. Total demand deposits of the banks now are Rs 10,000 (primary deposits) + Rs. 9,000
(Secondary deposits)= Rs. 19,000. The required cash reserves are = 10% of Rs. 19,000.
But the banks continue to hold cash reserves of Rs 10,000. So that, still there are excess
reserves, as under:

Excess Reserves = Actual reserves – Required reserves

= Rs. 10,000 – Rs. 1,900 = Rs 8, 100
Now the bank can further loan out their excess reserve of Rs. 8100 and their process
continues, till the required reserve become equal to actual reserve, therefore on the basis
of their cash reserve of Rs. 10,000, they have created money supply of equal to Rs.

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 1,00,000 [10,000 * 100/ 10] the money supply their created by the banks is called credit
money created by the bank.

Money Multiplier or Credit Multiplier

Using the above formula for the estimation of money/ credit creation, we can derive the
following equation indicating money multiplier or credit multiplier:

1
K=
RR

Here,

K = Credit multiplier, and

RR = Reserve requirement as a percentage of demand deposits of the commercial banks.

CRR
CRR refers to cash reserves of the commercial banks with RBI, as a percentage of their total
deposits.

In India, CRR hovers around 4% (precisely4% w.e.f. 09/02/2013) of the total deposits of the
banks. Given this fact, we can say that if commercial banks in india happen to receive fresh cash
deposit from the people and are able to put additional Rs 10,000 with RBI as cash reserves, then
the maximum additional credit/ money they can create is:

1
* 10,000 * 25 = Rs. 2,50,000
4%

The credit multiplier would work out to be:

1 1
K= = = 25
CRR 4 %

Often there is a difference between the actual money created by the commercial banks and the
maximum money that they can legally create on the basis of the given CRR. Why? Because,
besides CRR (cash reserves which the banks are legally bound to keep with the RBI) the
commercial banks often keep excess reserves with them as ‘vault cash’. [ In India, vault cash of

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the banks refers to their operative cash reserves, while CRR refers to sterilized cash reserves or
non- operative cash reserves.] Banks keep excess reserves to impart flexibility to their own credit
policy vis – a vis the credit policy of RBI.

Accounting for the excess reserves (or beyond the legally required reserves) the credit multiplier
formula is modified as under:

1
K=
CRR+VCR

Here,

CRR = Cash reserve ratio (cash to be legally kept with RBI as a percentage of deposits), and

VCR = Vault cash ratio (cash voluntarily kept by the banks in their vaults as some percentage of
their total deposits. This may also be called as ‘excess reserve’ ratio).

CDR
‘CDR’ is the other ratio that significantly impacts the process of money creation. It is cash
deposits ratio. Implying how much of additional cash released by the RBI and received by the
public is actually deposited (by the people) in the banks. Higher cash deposits ratio would mean
a greater rise in cash reserves of the commercial banks, leading to a proportionate rise in their
credit creation capacity, when CRR is given. People often hold a part of their money receipts in
the form of ‘cash balances’. This causes a drain in cash deposits with the banks, implying a drain
in cash reserves of the banks and a reduction in their capacity to create credit. Thus, banking
habits of the people must improve to facilities greater creation of credit by the banking system of
a country.

Statutory Liquidity Ratio (SLR)

It refers to liquid assets that the commercial banks must hold (on daily basis) as a percentage of their
total deposits. Like CRR, SLR is also determined by RBI in India and is a legal requirement to be fulfilled
by the commercial banks. Liquid assets include (i) cash, (ii) gold, and (iii) unencumbered approved
securities. The RBI uses SLR as yet another policy instrument to control credit creation capacity of the
banks.

LRR – Legal Reserve Ratio

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It is yet another ratio which finds reference in the context of credit creation or money creation by the
commercial banks. It is significant to note that LRR may refer to either CRR or SLR in the context of the
Indian banking system, though more often it points to CRR.

And, it is all the more significant to note that CRR and SLR should not be taken as components of LRR, in
the sense that CRR and SLR do not add up to anything like LRR. Thus, in India while CRR = 4% and SLR is
22%, these should not be added up to find LRR as equal to 26%. CRR and SLR are independently defined
by the RBI. Further, while CRR refers to only cash reserves of the commercial banks with RBI, SLR
includes three components, viz., cash, gold, and unencumbered approved securities to be held by the
commercial banks with themselves. Yet another difference: while estimating CRR, inter – bank claims
are NOT included in total deposits of the banks, in case of SLR, these are include. At best, CRR and SLR
may be taken as two types of reserve ratios rather than as two different components of LRR.

Primary and Secondary Deposits

Primary deposits are cash deposits with the commercial banks by the people. These are reflected as a
part of ‘demand deposits’ of the banks.

Secondary deposits are those deposits which arise on account of loans by the banks to the people.
These are also reflected as a part of ‘demand deposits’ of the banks.

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