BANKING
Commercial Bank: A commercial bank is that financial institution which accepts deposits from the
people and offer loans for the purpose of consumption and investment.
Functions: Commercial Banks perform two types of function:
(i) Primary function
(ii) Secondary function
Primary function: Commercial Bank performs two primary functions:
1. Accepting Deposits: A bank accepts deposits from the public. People can deposit
their cash Balances as Chequeable and non-chequable in either of the following
accounts:
(a) Fixed or Time Deposits A/c
(b) Current or Demand deposits a/c
(c) Saving Deposit A/c
2. Advancing loans: Bank advance loans mostly for productive purpose against some
approved security. The amount of loan is generally less than the value of the security.
Amount of loan never paid in cash. All loans are reflected as demand deposits with the
banks. Bank offers following types of loans:
(a)Cash Credit
(b)Overdraft
(c)Demand loans
Secondary function of commercial Bank:
(a) Agency function:
(i) Collection and payment of various items
(ii) Sale and purchase of securities
(iii) Sale and purchase of foreign exchange
(iv) Letter of reference
(v) Trustee and Executor
(vi) Under writer
(b) General Utility function:
(i) Locker facilities
(ii) Travelers cheque
(iii) Collection of Business Information
(iv) Help in transportation of Goods
(v) Credit Creation
(vi) Encouraging savings
(vii) Bank draft
Central Bank
The Central Bank: It is the apex bank that controls the entire banking system of a 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:
(i) Issuing of Notes: Central bank of a country has the exclusive right of issuing notes.
Actually, till the beginning of 20th century, the central bank was known as Bank of
Issues. In India, RBI has the sole right of issuing paper currency except one rupee notes
and coins, which are issued by ministry of finance. All the currency issued by the central
bank is its monetary liability, i.e. central Bank obliged to back the currency with assets of
equal value, to enhance the public confidence in paper currency.
(ii) Banker of the Government: Central Bank is a banker, agent and financial advisor to
the government. It manages accounts of the government banks across all in the country.
As an agent to the government, it buys and sells securities, Treasury bill on behalf of
the government. It helps the government in framing policies to regulate the money
market. As an agent, the central bank also has a responsibility of managing the public
debt. As a financial advisor, the central bank advices the government from time to time
on economic, financial and monetary matters.
(iii) Banker’s Bank: It is an apex bank of all banks in the country. The central Bank has
almost the same relation with other bank as a commercial bank has with its customers.
The central Bank keeps some cash balance of the commercial bank.
Supervision of the Banks: As a banker’s bank, the central Bank also supervise the
commercial bank. The supervision of commercial Banks relates to
a) Licensing of Banks
b) Expansion of the Banks
c) Merger of different Bank
d) Liquidation
Lender of the Last Resort: It means that if a commercial bank fails to get financial
accommodation from anywhere. It approaches the central Bank as a last resort. Central
Bank advances loan to such a bank against approved securities.
Clearing House function: Central Bank performs the function of clearing payments. All
commercial banks have their accounts with the central bank, therefore the central bank
can easily settle claims of various commercial banks against each other’s, by making
debit and credit entries in their accounts.
(IV) Custodian of Foreign exchange: The central Bank maintains foreign exchange reserves in
order to promote international trade and stabilize exchange rate.
(V) Control of Money Supply and Credit: Central Bank Control supply of money or credit. During
inflation, the supply of money is restricted and during deflation the supply of money is liberalized.
Monetary Policy:
It refers to that policy through which the central bank controls the supply of money, availability of
money and interest rate. It has following instrument:
1. Quantitative instrument
2. Qualitative instrument
Quantitative instrument
(a) Bank Rate : Bank rate is the rate at which central bank lends money to commercial bank
to meet their long-term needs.
(b) Repo rate When the commercial banks are in need of funds for a short period, they can
borrow from the central bank against approved securities. The rate of interest charged by
the central bank on such lending is called Repo Rate.
(c) Reverse Repo Rate (RRR): When the commercial banks have surplus funds, they can
deposit the same with the central bank and earn interest paid by the central bank on such
deposits is called reverse repo rate.
(d) Open market operations: It refers to purchase and sale of government securities in the
open market (Public and commercial banks) by the central Bank.
(e) Legal Reserve Requirements (LRR): Legal reserve requirement is that fraction of
deposits of commercial banks which is legally compulsory for them to maintain on two
accounts:
i. Cash Reserve Ration (CRR): It is the minimum percentage of deposits of
commercial bank (net of demand and time liabilities) which is kept in cash form with
RBI.
ii. Statutory Liquidity Ratio (SLR): It is the percentage of deposits of commercial
banks (net of demand and time liabilities) which every bank is required to maintain
with itself in the form of designated liquid assets. Liquid assets may be:
Excess cash reserve
Unencumbered government and other approved securities.
Current account balances with other banks.
Qualitative Measures
(a) Imposing margin requirement: A margin is the difference between market value of the
security offered by the borrower against the loan and the amount of the loan granted. It is
also defined as the discount fixed by RBI on the assets mortgaged as security to the
commercial banks e.g., if margin requirement is 20% then the bank is allowed to give loan
only upto 80% of the value of securities.
(b) Moral suasion: It is a combination of persuasion and pressure that the central Bank
applies to other banks in order to get them fall in line with its policy. It is done through
letters, speeches and hints to the banks.
(c) Selective Credit Control: This can be applied in both a positive as well as a negative
manner.
In a positive manner, the credit will be channelised to particular priority sectors.
In a negative manner, the flow of credit will be restricted to particular sectors.
Credit creation:-
i. Credit creation refers to the powers of commercial banks to expand secondary deposits
either through the process of making loans or through the investment in securities. In short,
creation of secondary deposits is called credit creation.
ii. Credit expansion powers of the commercial banks depend on two factors:
(a) Amount of initial fresh deposit (Primary deposit) The deposits of households and
firms held by a bank are called primary deposits.
(b) LRR= Legal Reserve Ratio or reserve Deposit Ration
iii. Total money creation (Credit Creation) = Initial deposit X 1/LRR.
Let us illustrate the process of credit creation by an example. Let us suppose that every
bank has to keep a cash reserve of 20% against its total deposits and its primary
deposit is ₹1000 cr.
Steps of working of money/credit creation by a commercial bank
Assumptions:
(1) Entire commercial banking is one unit.
(2) All monetary exchanges are routed through banks.
Credit Creation= Primary Deposits x 1/LRR
= ₹1000 x 1/20%
= ₹ 5000
(It shows that if legal reserve ration is 20%, then with initial/primary deposit of ₹1000, a
commercial bank will be able to create ₹5000 worth of deposits.)
Let us see how this happens
Working of money Creation by Commercial Banks
Rounds of Deposits LRR Loans
transactions
First Round 1000 (Primary Deposits) 200 800
Second Round 800 (secondary Deposits) 160 640
Third Round 640 (secondary Deposits) 128 512
Fourth Round 512 (Secondary Deposits) 102.4 409.6
Fifth Round 409.6 (secondary Deposits) 81.92 327.68
------------------ ----------------- -------------- --------------
---------- 5000 1000 4000
The bank will keep 20% of 1000 (primary deposit) to meet any demands arising out
of its liabilities to its depositors and lend the remaining amount of ₹800.
Borrowers will use this money and the money will come to the banking system (as
borrowers would most probably pay in form of cheques drawn on bank).
Now 800 will be derivative deposit, bank will keep 20% of 800 in reserve and lend
out remaining 640 to borrowers.
640 will be next derivative deposit, bank will keep 20% of ₹640 in reserve and lend
out remaining 512 to borrowers.
So in every round 80% of derivative deposits go in creation of credit and 20% go to
reserves.The process continues till the primary deposit of ₹1000 is completely
exhausted. The original deposit of ₹1000 becomes additional deposits of ₹800, ₹640
etc. The total of all these deposits will be ₹5000.
Practice Questions
1. Differentiate between Commercial Banks and Central Bank.
2. How RBI us qualitative and quantitative methods to control money flow in the market.
