CH 6: BANKING

Meaning of Commercial Bank

 A commercial bank is a financial institution which performs the functions of

accepting deposits from the public and advancing loans to the public with the aim
of making profits.
 Commercial bank charge a high rate of interest on loans and give lesser rate of
interest on deposits. The difference between these two rates of interest is the
amount of profit of the commercial banks. This also known as ‘spread’.
Points to Know about Money creation
Following observations explain the process of money creation by the commercial banks:
 Banks receive cash deposits from the people. These are called 'primary deposits'.
 Banks lend money many times more than their cash reserves.
 Money is lent by the commercial banks not in the form of cash, but in the form of 'credit
entry' in the accounts of the borrowers. These credit entries are known as secondary
deposits.
 The borrowers can issue cheques against 'credit' (loans) in their accounts. The cheques
circulate in the economy as money.
 Primary deposits + Secondary deposits = Demand deposits held by the people in the
commercial banks
 All demand deposits (held by the people) serve as money supply in the economy, just
like cash held by the people.
 Demand deposits serving as money supply is called bank money.
Credit creation or money creation by
commercial bank
 This is one of the most important activities of the commercial bank. Through the
process of money creation commercial banks are able to create credit which is for
excess of the initial deposit. For better understanding of the process we assume that:
1) The entire commercial banking system is one unit and is termed as banks
2) All receipts and payments in the economy are routed through banks.
 Banks receive cash deposits from the people, these are called primary deposits. It is
legally compulsory for the banks to keep a certain fraction of their deposits as
reserves. This fraction is called Legal Reserve Ratio (LRR) or Cash Reserve Ratio
(CRR) and it is fixed by the Central Bank.
 Banks know from their experience that all the depositors do not withdraw all the
money at the same time and there is a constant flow of new deposits into the banks.
ROUND DEPOSITS LOANS CASH RESERVES
(CRR)or LRR

1 ₹ 1000 ₹ 800 ₹ 200

2 ₹ 800 ₹ 640 ₹ 160

3 ₹ 640 ₹ 512 ₹ 128

.. .. .. ..

TOTAL ₹ 5,000 ₹ 4,000 ₹ 1,000

As we seen the table, the banks are able to create deposits of ₹ 5000 with the initial deposit
of just ₹ 1000. it means the total deposits become “five times” of initial deposits. Here Five
times is nothing but the value of money multiplier.
 Let us suppose primary deposit in the bank is ₹ 1000 and LRR is 20%. It means
banks are required to keep only ₹ 200 as cash reserve ratio and are free to lend ₹
800 .Banks do not lend this money by giving amount in cash rather they open an
account in the name of the borrowers who are free to withdraw the amount
whenever they like.
 Suppose borrowers withdraw the entire amount of ₹ 800 for making payments.
As all the transactions are routed through banks, the money spent by borrowers
comes back into the banks in the form of deposit of those who have received this
payment.
 With new deposit of ₹ 800 banks keep 20% of 800 i.e ₹ 160 as cash reserve and
lends the balance i.e. ₹ 640. Again, the money comes back into the banks in the
account of those, who receive this payment. This time bank deposit increases by
₹ 640. This process comes to an end when total cash reserve becomes equal to
initial deposit.
 As we seen the table, the banks are able to create deposits of ₹ 5000 with the
initial deposit of just ₹ 1000. it means the total deposits become “five times” of
initial deposits. Here Five times is nothing but the value of money multiplier.
 Thus if primary deposit = ₹ 1,000
CRR =20%
Total money creation = Primary deposit x 1/CRR
= ₹ 1000 x 1/20% =1000 x 100/20
= ₹ 5,000

Money Multiplier :
Money Multiplier or Deposit Multiplier measures the amount of money that the Banks able to create in
the form of deposits with every unit of money it keeps as reserves. It is calculated

Money Multiplier=

In the given example , LRR is 20% or 0.2 so,

Money multiplier = = = 5
Meaning of Central Bank
 The central bank is the apex bank in the country. It enjoys the apex
position in the country’s monetary and banking structure. It regulates and
monitors the banking and monetary system in the country.
 In India, the Reserve Bank of India is the Central bank it was established
in 1935. Some of the prominent central banks include Bank of England,
Federal Reserve Bank (USA), People’s Bank of China and so on.
FUNCTIONS OF CENTRAL BANK

Issue of Currency Notes:

 The central bank has the authority to issue currency notes. The RBI enjoys the monopoly of
note issue. The RBI has been authorised by the Government of India to issue notes of all
denominations except One Rupee note (which at present is rarely in circulation) the one
rupee note is directly issued by the government of India.

Government’s banker, agent, and advisor:

 Implies that a central bank performs different functions for the government. As a banker,
the central bank performs banking functions for the government as commercial banks
performs for the public by accepting the government deposits and granting loans to the
government.
 As an agent, the central bank manages the public debt, undertakes the payment of interest
on this debt, and provides all other services related to the debt.
 As an advisor, the central bank gives advice to the government regarding economic policy
matters, money market, capital market, and government loans. Apart from this, the central
bank formulates and implements fiscal and monetary policies to regulate the supply of
money in the market and control inflation.
The banker to other banks:
 As the banker to other banks the central bank gives direct advances against the
government securities or bill rediscounting facilities to other banks. The latter is required
to maintain a portion of their total deposits as cash reserve ratio (CRR) at the central bank.
By varying this reserve ratio, the central bank can control the advances of other banks.
Besides, the central bank controls and supervises the operations of other banks through
licensing, inspection of bank accounts, bank mergers, etc.

The custodian of the nation’s gold and foreign exchange reserve:

 The central bank keeps the nation’s gold and foreign exchange reserve under its direct
supervision. The central bank is required to maintain the rate of exchange, i.e., the external
value of the currency .It has to conduct foreign exchange operations at some specified
exchange rates. It also exercises the exchange control, i.e., control of foreign exchange.

Lender of last resort:

 As commercial banks lend to the individuals, the central bank lends to the commercial
banks in times of unanticipated emergencies. Thus, the central bank assumes the
responsibility of meeting, directly or indirectly, all the reasonable demands for funds by
commercial banks in times of difficulty and crisis. A commercial bank can borrow from
the central against eligible securities.
Bank of central clearance, settlement, and transfer:
 Implies that the central bank helps in settling mutual indebtedness between commercial
banks. Depositors of banks give cheques and demand drafts drawn on other banks. In such
a case, it is not possible for banks to approach each other for clearance, settlement, or
transfer of deposits.
 The central bank makes this process easy by setting a clearing house under it. The central
bank holds excess reserves of banks to meet any clearing drains due to settlement with
other banks. The claims of one bank against other are conveniently settled by simple
transfer from and to their accounts from these cash reserves (debit and credit transactions
to settle claims of banks with each other through RBI)

Controller of Credit:
 Implies that the central bank has power to regulate the credit creation by commercial
banks. The credit creation depends upon the amount of deposits, cash reserves, and rate of
interest given by commercial banks. All these are directly or indirectly controlled by the
central bank. For instance, the central bank can influence the deposits of commercial banks
by performing open market operations and making changes in CRR to control various
economic conditions.
Controller of Credit and Money Supply

Monetary Policy of Central Bank refers to the policy of Central Bank related to the control
of money supply and availability of the credit in the system.
The measures of monetary policy are:

Quantitative Measure Qualitative Measure

These measures influence the total These instruments are used to
amount of money regulate the direction of credit.
supply in circulation. These are: They are as under:
1. Bank Rate/ Discount Rate 1. Margin requirements
2. Repo Rate 2. Moral Suasion
3. Reverse Repo Rate 3. Selective Credit Controls
4. Open Market Operation (OMO)
5. Varying Reserve Requirements (CRR
and SLR)
QUANTITATIVE INSTRUMENT
1. Bank Rate/ Discount Rate: It is the minimum rate at which the Central Bank of the country gives credit to
the Commercial Bank to meet their long term needs.
To control:
(a) Inflation/ Excess demand: Central bank rises bank rate that discourages commercial banks in
borrowing from central bank as it will increases the cost of borrowing of commercial bank. It forces the
commercial banks to increase their lending rates, which discourages borrowers from taking loans which
discourages investment. Again high rate of interest induces household to increase their savings by
restricting expenditure on consumption. Thus expenditure on investment and consumption is reduced,
which will control the excess demand.
(b) Deflation/Deficit demand: Central bank decreases bank rate that encourages commercial bank in
borrowing from Central bank as it will decrease the cost of borrowing of commercial bank. Decrease in
the bank rate makes commercial bank to decrease their lending rates, which encourages borrowers
from taking loans, which encourages investment. Again low interest rate induces households to
decrease their savings by increasing expenditure on consumption. Thus expenditure on investment and
consumption increases, which will control the deficit demand.
 2. Repo Rate: Repo Rate is the rate at which commercial bank borrow money from the central bank
for short period by selling their financial securities to the central bank.
To control:
(a) Inflation: Central bank rises repo rate that discourages commercial banks in borrowing from
central bank as it will increase the cost of borrowing of commercial bank. Commercial banks will
increase their lending rates, which discourages borrowers from taking loans, which discourages
investments. Again high rate of interest induces household to increase their savings by restricting
expenditure on consumption. Thus expenditure on investment and consumption is reduced,
which will control the excess demand.
(b) Deflation: Central bank decreases Repo Rate that encourages commercial bank in borrowing from
central bank as it will decrease the cost of borrowing of commercial bank. Decrease in Repo Rate
makes commercial bank to decrease their lending rates, which encourages borrowers from taking
loans, which encourages investment. Again low rate of interest induces household to decrease
their savings by increasing expenditure on consumption. Thus expenditure on investment and
consumption increases, which will control the deficient demand.
3. Reverse Repo Rate: It is the rate at which the Central Bank borrows money from commercial bank.
To control:
(a) Inflation: In a situation of excess demand leading to inflation, Reverse repo rate is increased, it
encourages the commercial bank to park their fund with the central bank to earn higher returns on
idle cash. It decreases the lending capability of commercial bank, which controls excess demand.
(b) Deflation: In a situation of deficient demand leading to deflation. Reverse repo rate is decreased, it
discourages the commercial bank to park their fund with the central bank. It increases the lending
capability of commercial bank, which controls deficient demand.

4. Open Market Operation (OMO): It consists of buying and selling of government securities and bonds
in the open market by Central Bank.
To control:
(a) Inflation: In a situation of excess demand leading to inflation, central bank sells government
securities and bonds to commercial bank. With the sale of these securities, the power of
commercial bank of giving loans decreases, which will control excess demand.
(b) Deflation: In a situation of deficient demand leading to deflation, central bank purchases
government securities and bonds from commercial bank. With the purchase of these securities, the
power of commercial bank of giving loans increases, which will control deficient demand.
5. Varying Reserve Requirements: Banks are obliged to maintain reserves with the central bank, which
is known as legal reserve ratio. It has two components. One is the Cash Reserve Ratio or CRR and the
other is Statutory Liquidity Ratio or SLR.
i) Cash Reserve Ratio: It refers to the minimum percentage of banks total deposits, which is
required to keep with the central bank. Commercial banks have to keep with the central bank a certain
percentage of their deposits in the form of cash reserve as a matter of law.
Eg. If the minimum reserve ratio is 10% and the total deposit of a commercial bank is Rs 100 crore, it will
have to keep Rs 10 crore with the Central Bank.
To control:
(a) Inflation: In a situation of excess demand leading to inflation, Cash Reserve Ratio is raised to 20%,
the bank will have to keep Rs 20 crore with the Central Bank, which will reduce the cash reserves of
commercial bank and reducing credit availability in the economy which will control excess demand.
(b) Deflation: In a situation of deficient demand leading to deflation, Cash Reserve Ratio falls to 5%, the
bank will have to keep Rs 5 crore with the central bank, which will increase the cash reserves of
commercial bank and increasing credit availability in the economy, which will control deficient
demand.
 ii) The Statutory Liquidity Ratio: It refers to minimum percentage of liquid assets which all commercial
banks are required to maintain with themselves. In India it is around 22 percent.
Liquid assets may be:
 Cash
 Unencumbered government and other approved securities.
Unencumbered government securities are government bonds or other debt securities that are not used as collateral for loans
or other financial obligations. In other words, they are not subject to any legal or financial encumbrances that could affect
their ownership or transferability. In India, examples of unencumbered government-approved securities could include:
Government of India Treasury Bills , Government of India Dated Securities, State Development Loans (SDLs) etc.
 Gold
To control:
a) Inflation: In a situation of excess demand leading to inflation, the central bank increases statutory liquidity
ratio, which reduce the cash reserves of commercial bank and reducing credit availability in the economy.
b) Deflation: In a situation of deficient demand leading to deflation, the central bank decreases statutory
liquidity ratio, which will increase the cash resources of commercial bank and increases credit availability
in the economy.
QUALITATIVE INSTRUMENT
1) Imposing Margin requirements: 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 requirements is 20% then
bank is allowed to give loan only up to 80% of the value of the securities.
To control:
a) Inflation: In a situation of excess demand leading to inflation, central bank raises marginal
requirements. This discourages borrowing because it makes people get less credit against their securities.
b) Deflation: In a situation of deficient demand leading to deflation, central bank decreases marginal
requirements. This encourages borrowing because it makes people get more credit against their securities.

2) Moral Suasion: Moral suasion implies persuasion, request, informal suggestion, advice and appeal by the
central bank to commercial banks to cooperate with general monetary policy of the central bank.
To control:
a) Inflation: In a situation of excess demand leading to inflation, it appeals for credit contraction.
b) Deflation: In a situation of deficient demand leading to deflation, it appeals for credit expansion.
3) Selective Credit Controls: In this method the central bank can give directions to the commercial
banks not to give credit for certain purposes or to give more credit for particular purposes or to the
priority sectors.
a) Inflation: In a situation of excess demand leading to inflation, the central bank introduce
rationing of credit in order to prevent excessive flow of credit, particularly for speculative activities.
Which helps to wipe off excess demand.
b) Deflation: In a situation of deficient demand leading to deflation, central bank withdraws
rationing of credit and make efforts to encourage credit.