Department of Economics (Girls Shift)

Grade - 12
BANKING
Commercial banks are financial intermediaries whose main function is to accept deposits from
general public and extend loans to the households, firms, and government.

PRIMARY FUNCTIONS OF COMMERCIAL BANKS

1. Accepting deposits: The most important function of a commercial bank is to accept

deposits and mobilize the savings of the community. The deposits are classified into:

a) Demand deposits: They are those deposits which are withdraw able on demand. The
demand deposits can be classified into:

Savings bank account: It is a kind of demand deposit which is generally kept by people for the
sake of safety. This facility is given for small savers and normally a small rate of interest is paid
on this account.

Current account deposits: They are mainly maintained by the business community to facilitate
frequent transactions with big amounts. Such accounts are mostly held by companies,
institutions, government and private businessmen, etc. Generally no rate of interest or very low
rate of interest is paid on current account.

b) Time deposits: Time deposits are those which can be withdrawn only after a specified period
of time. The time deposits can be classified as follows:

Short term deposits: Maturity period of these deposits is very short but specific. Rate of
interest if relatively less on these deposits.

Fixed deposits: Under this account money is deposited for a certain fixed period of time. It
earns a higher rate of interest than other forms of deposits. Depositors can keep for period
ranging from 15 days to 5 years or more. If money is withdrawn before the expiry of time, a
depositor earns a lower rate of interest.

Recurring deposits: Such deposits encourage the habit of small saving among the people. In
such account, depositors are expected to deposit a specified amount at a regular interval i.e.,
usually a month. Interest on this type of deposit is almost equal to that of fixed deposits.
2. Advancing loans: Giving loans is another very important function of commercial banks.
Banks accept deposits at a lower rate of interest and give loans and advances at a higher rate of
interest. In this way they earn profits .Banks give loans in the following ways:

Overdraft facility- in which the depositor gets the right to draw cheques on the bank upto an
agreed amount in excess of the borrower’s deposits.

Discounting bills of exchange- where the customers are put in possession of money before the
bills in their possession mature.

Advancing outright loans and advances- usually commercial banks give loans for short and
medium period. Banks charge interest from the borrowers.

3. Transfer of funds: Banks manage transfer of funds by the following ways:

Demand draft: It is a cheque drawn by one branch of the bank on another branch of it.

Main transfer: It is an advice sent by one branch of the bank by mail or telegram to another
branch to credit the account.

Traveler’s cheque: These are issued by commercial banks to the depositors who want to travel
within the country or abroad.

4. Development of cheque system: Development of cheque system is an important

function of banks in settling debts. It is more convenient to use cheques than the use of cash.
Cheques are of two types- 1. Bearer cheque 2. Crossed cheque. Bearer cheque can be encashed
immediately when presented at the bank by the bearer of it. A crossed cheque is the one in
which two parallel lines are drawn at the left hand side corner of the cheque. Such cheques
cannot be exchanged easily but has to be deposited in the payee’s account. It is a safe cheque.

5. Credit creation: Credit creation is a unique function of the commercial banks. Commercial
banks give loans against the securities to safeguard the interest of the depositors. However, the
amount of loan is not given in cash but it is credited in the account of the borrower and they
can withdraw whenever they need, but they have to pay interest on the amount borrowed. This
is called credit creation.

6. Remittance of funds: Commercial banks help their customers in remitting funds from one
place to another by issuing bank drafts, mail transfers, etc. by charging some commission.
SECONDARY FUNCTIONS OF COMMERCIAL BANKS (FOR REFERENCE ONLY)
Non-banking or secondary functions: Commercial banks are not just financial agents but they
perform following useful non-banking functions-

Agency functions:
a. Commercial banks act as agents to their customers to make payments of insurance premium,
personal taxes, electricity bills, etc. and receive payments of insurance claims, pension claims,
dividends, etc.

b. Banks buy and sell gold, silver and other securities on behalf of their customers.

c. They also act as a trustee and execute the bills of the deceased.

d. They deal in foreign trade, that is, they issue letter of credit and provide guarantees to
foreign leaders for the soundness of the customers.

General utility functions:

a. Commercial banks provide safe deposits locker facility to its clients to keep their valuables.

b. Banks collect information about trade and finances and publish the same, that is, they advise
their customers.

c. They provide credit card facility to make easy payments.

d. They issue traveler’s cheque to the customers to avoid the risk of carrying money from one
city to another.

e. Gift cheques are also issued by the banks.

HOW DO COMMERCIAL BANKS CREATE CREDIT?

Money/credit creation is an important function of the commercial banks. By creating credit,
commercial banks contribute to money supply in the economy. They create credit in the form
of demand deposits. Demand deposits of the commercial banks are many times more than
their cash reserves. If cash reserves are (say) Rs1, 000 and if demand deposits are (say) Rs10,
000, then the commercial banks are creating credit ten times of their cash reserves.
Accordingly, on the basis of cash reserves of Rs1, 000, the commercial banks are contributing
Rs10, 000 to the supply of money. The process of credit creation is like this:

Initially, bank receives deposits of Rs1, 000. The required reserves to tackle the liability of
Rs1,000 is equal to Rs100 (on the assumption that cash reserve ratio is 10% of total deposits).
Implying that the banks have excess reserves= Rs1,000-Rs100 = Rs900 which they can use for
the purpose of lending. When these excess reserves are loaned out, total deposits of the banks
amount to Rs1,000 + Rs900 = Rs1900. The bank need to hold cash reserves as 10% of 1,900 or
190, while their actual reserves are Rs1000. Implying excess reserves of Rs1000 - Rs190 = Rs810
which can be loaned. This process continues till total demand deposit are Rs10,000 and cash
reserves are Rs1,000.

Thus, if required reserve ratio is equal to 10%, total cash reserves of Rs1,000 allows the bank to
create demand deposits up to Rs10,000. So that,

1
Demand Deposits= x Cash Reserves
RR

1
= x Rs1, 000
10 %

= 10 x Rs1, 000

= Rs10, 000

Here, RR refers to reserve requirement of the commercial banks as a percentage of their

demand deposits.

Here, it is important to note that loans are never offered in cash. These are always reflected as
demand deposits in favour of the borrowers. Accordingly, when loans are offered, demand
deposits of the banks tend to build up. In the above example, cash reserves of Rs1,000 allow
demand deposits of Rs10,000, which serve as a source of money supply.

CENTRAL BANK
A central bank controls monetary and the banking system. It is the agency through which the
state enforces the monetary part of its economic policy.

A central bank performs many important functions, these are:

Monopoly of note-issue: In most countries, the central bank enjoys the monopoly of note-
issue. As such, it can function as the monetary authority and exercise control over the volume
of the currency of a country. The issue department of the central bank is responsible for note
issue.

Government’s bank: A central bank performs most of the monetary functions on behalf of
the government. The government and municipalities have their accounts in the central bank. It
acts as the custodian of the government funds and manager of public debts. It helps the
government in floating new loans and even advices the government in the formulation and
execution of monetary policy. In short, the central bank is an agent, adviser and banker to the
government.

Banker’s bank: A central bank acts as the banker of all the other banks in the country. It
supervises and controls the function of all the banks. All banks are expected to keep certain
cash reserves with the central bank. So it acts as the custodian of the cash reserves of banks.
Lender of the last resort: Whenever a bank is in difficulty or doesn’t have the cash to pay to
customers, it approaches the central bank for help. The central bank rediscounts the bills of
exchange or gives loan. The rate of interest charged for such loans is known as bank rate. It is
the duty of the central bank to come to the rescue of the banks which are sound but are in
difficulty for a short time. Therefore, the central bank is called the lender of the last resort.
Clearing house: A central bank arranges for the clearing of cheques through the clearing
house. Clearing of cheques enables banks to settle their mutual use by the process of book
entries. This facilitates payments without the actual use of cash in the economy. Thus interbank
payments are facilitated by the clearing system.

Exchange control: A central bank controls all the foreign exchange dealings of a country. It
acts as the custodian of the foreign exchange reserves. It is the central bank’s duty to stabilize
the exchange value of the home currency. For stabilizing the rate of exchange,a central bank is
always prepared to buy or sell foreign currencies at the rates fixed by it. It looks after the
balance of payment position of a country and adopts certain measures or advises the
government to adopt the measures to ensure sound balance of payment position.

Controller of credit: A central bank controls credit created by the banks in a country. Banks
may advice unduly more or less credit. A central bank sees that the volume of credit in the
country is adequate. It has also to see that the credit created by the banks is used for
constructive and productive purposes. It ensures that excessive bank credit is not used for
speculative activities or to rig prices or to hoard essential goods.

Promoter of development: A central bank also helps the government in its efforts to
promote economic development by developing the financial sector of the economy. It helps the
government in fulfilling the economic objectives such as increasing employment and
maintaining price level and stimulating economic growth.

Credit control measures by the central bank

QUANTITATIVE TOOLS OF CREDIT CONTROL- these control the overall volume of credit

Bank Rate or Repo Rate: Bank rate is the rate of interest charged by the central bank to the
commercial banks while advancing money against securities or by rediscounting eligible bills of
commercial banks. When the bank rate is increased, the cost of borrowing from the central
bank goes up. So, commercial banks in turn charge higher rate of interest on loans sanctioned
to cover up their increased cost. This brings down the demand for bank credit from public as
loans become costly. Thus when central banks aim at contraction of credit supply in the
economy, it increases the bank rate and reverse is done to increase the volume of credit supply.

Open Market Operations: OMO refers to purchase or sale of government securities, trade
bills, etc. by the central bank to people, banks and other financial institutions. Hence the term
“open market operations” is used.OMO regulates the credit creation power of the commercial
banks during inflation or recession in the economy. During inflation, when the central bank sells
its securities in the open market, cash balance in the hands of the public or the banks will be
reduced. Reduction in cash reserves with the banks will raise the rate of interest and reduce
their credit creation capacity. Similarly central bank purchases the securities during recession
which increases the cash reserves with the banks and the banks will be able to expand credit
which will decrease the rate of interest.

Cash reserve ratio/Statutory ratio: CRR requires the commercial banks to maintain
certain minimum cash reserve with the Central Bank as a percentage of their total deposit. SLR
liquid assets. The liquid assets include (a) Cash reserves held by the commercial banks with
themselves. (b) Gold reserves of commercial banks. When CRR and SLR are raised (as during
inflation) credit creation capacity of the commercial banks is reduced. On the other hand when
CRR and SLR are lowered (as during deflation) credit creation capacity of commercial banks is
increased.

Qualitative or Selective tools of credit control - refers to control of credit in some

directions only. Credit is encouraged and provided at lower rate of interest as it is done in India
for priority sector and production of non-essential goods are discouraged. Under this method
following tools are used:
a. Change in margin requirements: Margin refers to the difference between the market
value of security and the loan given. Suppose margin requirements are 40%, then the loan
advanced will be market price of a security minus margin. If the market price of a security is
1lakh, then loan sanctioned will be upto 60% i.e., upto Rs60, 000 only. Hence central bank may

increase the margin to reduce the amount of credit that may be advanced by commercial banks
and vice versa. Margin fixed for different types of securities is different.

b. Consumer credit regulation: Banks give credit to consumers to buy durable consumer
goods like TV, cars, scooters, etc., such credit can be controlled through initial payment and
number of installments. If the minimum down payment is increased and the period for the
repayment of installments is reduced, the demand for consumer credit would be reduced and
vice versa.

C. Control by directives: Central bank issues directives (threat) written or oral to the
commercial banks to follow some certain line of action to avoid certain types of credit or to
keep their credit limits low in certain cases.

d. Direct action: Central bank may resort to direct action against defaulting banks. It may
refuse to rediscount the bills if banks credit policy is not in accordance with the policies of the
central bank or if their borrowings are in excess of their required cash reserves. Such direct
action has been taken by many central banks including RBI.

e. Moral suasion: It refers to request or appeal made by central bank to commercial banks
to follow a particular line of action by way of calling meeting of the heads of commercial banks,
letters, and oral requests etc., to reduce their loans for speculation or for non-essential
activities. Central bank persuades commercial banks.

f. Rationing of credit: Under this method central bank may fix a ceiling of loans and
advances for commercial banks by way of rediscounting bills or it can fix the credit quota for
each bank.

DISTINGUISH BETWEEN COMMERCIAL AND CENTRAL BANK

The principle differences between commercial and central bank are as follows:

Central Bank Commercial Bank

Central bank functions as the apex bank of the Commercial banks function according to the
country. rules and regulations stipulated by the Central
bank.
The Central bank designs and controls all Commercial banks only execute the monetary
instruments of monetary policy of the country.
Central bank is the sole authority of note
issuing.
Central bank does not deal directly with the
general public. It does not accept deposits or
advance loans.
policy as directed by the Central bank.
Commercial banks contribute to the flow of
money only by way of credit creation.
Commercial banks deal directly with the
general public by accepting deposits and
advancing loans.