CH.

5 BANKING

The Central Bank

● It is an apex institution which operates, controls, directs and regulates the
monetary and banking structure of a country.
● The design and control of the country's monetary policy is its main
responsibility .
● India’s central bank is Reserve Bank of India
❖ Functions Of Central Bank
1. Issue of Currency
● The central bank is the sole and only authority for the issue of currency in
the country .
● All the currency issued by central bank is its monetary liability .
● Notes issued by central bank are circulated as Legal Tender Money .
● By having the monopoly of the issue of notes , the central bank can restrict
or expand the supply of money according to the requirements of the
economy .
● It may be noted that RBI issues all the currency notes In India from Rs 2 and
above. (Rs. 1 coin is issued by ministry of final, central government)

2. Banker to the Government

● Central bank acts as a banker, agent and financial advisor of the
government .
● As the banker to the government, central bank accept the receipts and make
payments for the government.
● As government agent, Central bank conducts sale and purchase of
government securities and manage national and foreign debts
● The central bank also acts as advisor to the government especially on
monetary, banking and financial matters.
3. Banker’s bank
● Central bank keeps a part of cash balances of all commercial banks as
deposits which can be used by commercial banks at time of crises to meet
their liabilities
● It provides short term credits at times of difficulties .
● The central bank supervises, regulates, and controls commercial banks.
● The central bank is the bank of central clearance, settlements and transfers.
4. Lender of last resort
● If a commercial bank fails to get financial help from anywhere , it
approaches central bank as last resort .
● As commercial banks lend to the individuals, the central bank lands to
commercial banks in times of emergency.
● Central bank advances loan to such a bank against approved securities .
● This offers an opportunity for the central bank to establish its control over
the banking system of the country .
5. Supervisor of the banks
● Central bank supervises commercial banks in
✔ Licensing of the commercial bank
✔ Expansion of banks in terms of branches.
✔ Liquidation of banks
6. Control of credit
It controls credit activities of commercial banks to control situation of Inflation
or Deflation. (explained below after 8th point)
7. Custodian of nation’s reserve of foreign exchange
● It is the responsibility of central bank to keep the external money value of
country stable.
● It maintains foreign exchange reserves in order to promote international
trade and stabilize exchange rate .
● If there are fluctuations in the foreign exchange rate, the central bank may
have to buy and sell foreign currencies in the market.
8. Other functions
a. Agricultural credit
b. International monetary Conference
c. Money and bill market
d. Return of torn notes
e. Collection of statistics.
❖ Quantitative measures
a. These are meant to regulate the overall level or volume of credit in the
economy through commercial banks .
b. These measures are also known as general/indirect measures of credit
control.
❖ Qualitative measures
a. These aim at controlling specific type of credit .
b. These are known as selective / direct measures of credit control

Quantitative Instruments Of Monetary Policy

1. Bank rate :
❖ Meaning
● Bank rate is the rate of interest at which central bank lends funds (money) to
commercial banks. It is charged to commercial banks against the loand
issued to them by the central bank.
● In other words, it is the lending rate of the central bank at which it
rediscounts first class bills of exchange and government securities held by
the commercial banks.
❖ Increase in Bank Rate
● During excess demand or inflationary gap, central bank increases the bank
rate. Borrowings become costly and commercial banks borrow less from
central bank.
● Increase in the bank rate forces commercial banks to increase their lending
rates to the community and general public. This makes credit costlier. As a
 result borrowers borrow less from commercial banks for consumption and
investment.
❖ Decrease in Bank rate
● During deficient demand or deflationary gap central bank decreases or
lowers the bank rate. It is cheap to borrow from the central bank on the part
of the commercial banks.
● Commercial banks also decrease their lending rates. Businessmen are
encouraged to borrow more. Investment is encouraged. Output, employment,
income and aggregate demand starts rising.
2. Open Market Operations :
❖ Meaning
● Open market operations refer to the buying and selling of government
securities and bonds by the central bank from and to the general public and
banks.
❖ Sale of Securities
● During excess demand or inflation the central bank starts selling of
government securities in the market.
● The resources of commercial banks are reduced and they are not in a
position to lend more to the business community. This reduces the
investment and aggregate demand.
❖ Purchase of Securities
● During deficient demand or deflation, the central bank starts buying or
purchasing securities from the open market.
● The reserves of commercial banks are raised and they lend more.
Investment, output, income and aggregate demand start rising.
3. Cash reserve ratio :
❖ Meaning:
● CRR refers to minimum percentage of bank’s total deposits required to be
kept with central bank . for eg. If the minimum CRR is 10% and the total
deposits of a bank is 100 crore , it will have to keep 10 crores with itself .
❖ Increase in CRR
● During excess demand or inflation the central bank increases the cash
reserve ratio. An increase in the CRR has the effect of reducing the banks'
excess reserves and thus curtails their ability to give credit.
● In other words, the reserves of commercial banks are reduced and they lend
less. The volume of investment and aggregate demand will decrease.
❖ Decrease in CRR
 ● During deficient demand or deflation, the central bank decreases the cash
reserve ratio. A decrease in the CRR has the effect of increasing the banks'
excess reserves and thus increase their ability to give credit.
4. Statutory liquidity ratio (SLR)
❖ Meaning:
● Every bank is required to maintain a fixed percentage of its assets in the
form of cash or other liquid assets called SLR .
❖ Increase in SLR
● During excess demand or inflation the central bank increases the SLR. An
increase in the SLR has the effect of reducing the banks' excess reserves and
thus curtails their ability to give credit.
● In other words, the reserves of commercial banks are reduced and they lend
less. The volume of investment and aggregate demand will decrease.
❖ Decrease in SLR
● During deficient demand or deflation, the central bank decreases the SLR. A
decrease in the SLR has the effect of increasing the banks' excess reserves
and thus increase their ability to give credit.
● In other words, the reserves of commercial banks are raised and they lend
more. The volume of investment and aggregate demand will increase.
❖ Repo Rate and Reverse Repo Rate
● Repo rate is the rate at which commercial banks borrow money from central
bank (RBI). Whenever the banks have any shortage of funds they can
borrow it from central bank. Central bank lends money to bankers against
approved securities for meeting their day to day requirements or to fill short
term gap. A reduction in the repo rate will help banks to get money at
cheaper rate. When the repo rate increases borrowing from central bank
becomes more expensive.
● Reverse Repo rate is the rate at which central bank borrows money from
commercial banks. An increase in reverse repo rate can cause the
commercial bank to transfer more funds to central bank due to this attractive
interest rates. It can cause the money to be drawn out of the banking system.
Qualitative Instruments Of Monetary Policy
1. Margin Requirement :
● The margin requirement of loan refers to the difference between the current
value of security offered for loans and the value of loans granted .
2. Rationing of credit :
 ● It refers to the fixation of credit quotas for different business activities . It is
introduced when the flow of credit is to be checked particularly for
speculative activities in the economy .
3. Direct action :
● The central bank may initiate direct action against the member banks in case
these do not comply with its directives .
4. Moral pressure :
● Sometimes, the central bank makes the member banks agree through
persuasion or pressure to follow the directives with a view to control the
credit . The central bank has its control over all the commercial banks

COMMERCIAL BANKS
● It is that financial institution which provide loans to people and accepts their
deposits . They provide loans for purpose of investment and consumption .
❖ Functions :
There are two types of functions of commercial banks:
(A)Primary function (B) secondary function
These functions are explained below.
❖ Primary functions:
1. Accepting deposits :
● People can deposit their cash balances in bank , and they can deposit their
cash in following accounts according to their will .
a. Fixed deposit account :
● Cash is deposited for a fixed period of time . This type of deposit attracts
high rate of interest . If the depositor stands in need of amount before expiry
date , he can withdraw same after paying discount amount to bank
b. Demand deposit or Current Accounts :
● Ordinary businessman deposit their money in this account . They can
deposit and withdraw funds any number of time the depositor wishes to .
Generally no interest is paid by bank .
c. Saving Deposit account
● This account is meant for small savings . Bank pays interest on this account
but it is small as compared to interest rate of fixed account. A depositor can
withdraw till a certain limit .
d. Home safe saving account :
● It is a small portable safe provided to deposition at his place. Key is kept
with bank, the depositor puts small savings in it as convenient to him, and
sometimes hand over same to bank for depositing in account.
e. Recurring deposit account :
● Under this type of account, a specific amount is deposited every month for a
specified time. For eg. 12, 24 months etc.
● The amount cannot be withdrawn before the maturity date under exceptional
situations .

2. Advancing loans :
● Bank provides loans to people after keeping the reserve amount of deposits
given by public. Remaining amount is given as loans for productive
purposes. Some of these are as follows:
a. Cash credit :
● A debtor is allowed to withdraw a certain amount on a given security. Bank
charges interest on the amount which has been actually withdrawn.
b. Overdraft :
● The people having current account with the bank having a facility of
withdrawing more money, then they have in their accounts. This is called
overdraft.
c. Demand loans :
● Loans are given but without any specified maturity date. The interest is
chargeable on whole amount from the day loan is given. The loans are
offered against personal security.
d. Short term loans :
● These are secure loans as they are offered against some security. Interest is
given as personal loans or for finance working capital.
❖ Secondary functions :
1. Agency functions :
a. Bank collects various items on behalf of customer such as rent , interest , etc
. It also make payments taxes , insurance premium etc. On their behalf
b. Banks helps customer to sell buy and keep in safe custody the securities on
behalf of their customers .
c. Banks also act as trustees and executors of the property of their customers
on their advice .
2. General utility functions :
 a. Bank provides locker facilities to their customer for keeping valuable and
important documents, in these lockers .
b. Bank issues traveler’s cheque or letters of credit to their customer to avoid
the risk of carrying cash during journey .
c. Banks give advice to their customers on financial matters on the basis of
business information and statistical data collected by them .

❖ Role of commercial banks in economic development

1. Commercial bank help in capital formation by mobilising ideal saving of the
people by investing in some productive activities.
2. Banks determine low rate of interest, this encourages traders and
entrepreneurs to make more investment.
3. By providing loans , bank encourages innovates due to this new products
come to the market .
4. They help in development of rural sector , by giving liberal loans at
concessional rate of interest for purchase of tools and equipments and good
seeds for agriculture .
❖ Money creation by commercial banks : (Credit Creation)
● Money creation or Credit creation is the process of expansion of credit
through derivative deposit. It is done by the commercial banks with the
motive of earning interest income.
● Money creation or deposit creation by the bank is determined by:
1. The amount of initial fresh deposit or initial deposits.
2. The Legal Reserve Ratio (LRR)
It is the minimum ratio of deposits legally required by the commercial bank to
be kept as cash it has two components:
(a) Cash Reserve Ration (CRR): Part of LRR to be kept with the Central
Bank.
(b) Statutory Liquidity Ratio (SLR): Part of LRR to be kept by
commercial banks themselves.
❖ Process
1. Let the LRR be 20% and there is a fresh deposit (Initial deposit) of Rs.
10,000.
2. As required, bank keeps 20% i.e. Rs. 2,000 as cash. Suppose the bank lends
the remaining 8,000.
 3. Those who borrow use their money for making payments. As assured those
who receive payments put the money back in the banks. In this way bank
receive fresh deposits of Rs. 8,000. The bank again keeps 20% i.e. Rs. 16 as
cash and lend Rs. 6,400 which is also 80% of the last deposit.
● The money again comes back to the bank leading to a fresh deposit of
Rs. 6,400. The money goes on multiplying in this way and ultimately
total money creation is Rs. 50,000.
● Given the amount of fresh deposit the total money creation is:
1
● Total Money Creation = 𝐼𝑛𝑖𝑡𝑖𝑎𝑙𝐷𝑒𝑝𝑜𝑠𝑖𝑡𝑥 𝐿𝑅𝑅

1
= 10,000x 20% = 𝑅𝑠. 50, 000

Table: Money Creation by Commercial Banks

Rounds Deposits (Rs.) Loans (Rs.) Legal Reserve
Ratio (LRR
20%)
Initial 10,000 8,000 2,000
Round I 8,000 6,400 1,600
Round II 6,400 5,120 1,280
. . . .
. . . .
. . . .
. . . .
. . . .
Others 25,600 20,480 5,120
Total 50,000 40,000 10,000

❖ Money multiplier
Money multiplier measures how many times the total deposits would be of the
initial deposits , which is determined by CRR .
It is also known as “deposit multiplier ”.
1
Money multiplier (m) = 𝐿𝑅𝑅

Eg.LRR = 20%
1
M = 20 = 5

FACTORS AFFECTING CREDIT CREATION

⮚ Policy of RBI
⮚ Initial deposits
⮚ CRR
⮚ Banking habits of the people