Banks are financial institutions that accept deposits and grant loans. There are two main types of banks: commercial banks and central banks. Commercial banks accept deposits from the public and offer loans for consumption and investment purposes. Central banks act as the central authority that regulates the entire banking system of a country. Key functions of central banks include issuing currency, acting as a banker, agent and advisor to the government, overseeing commercial banks, acting as a lender of last resort, managing foreign exchange reserves, facilitating interbank clearing and settlement, and controlling the money supply to manage inflation and deflation.
Banks are financial institutions that accept deposits and grant loans. There are two main types of banks: commercial banks and central banks. Commercial banks accept deposits from the public and offer loans for consumption and investment purposes. Central banks act as the central authority that regulates the entire banking system of a country. Key functions of central banks include issuing currency, acting as a banker, agent and advisor to the government, overseeing commercial banks, acting as a lender of last resort, managing foreign exchange reserves, facilitating interbank clearing and settlement, and controlling the money supply to manage inflation and deflation.
Banks are financial institutions that accept deposits and grant loans. There are two main types of banks: commercial banks and central banks. Commercial banks accept deposits from the public and offer loans for consumption and investment purposes. Central banks act as the central authority that regulates the entire banking system of a country. Key functions of central banks include issuing currency, acting as a banker, agent and advisor to the government, overseeing commercial banks, acting as a lender of last resort, managing foreign exchange reserves, facilitating interbank clearing and settlement, and controlling the money supply to manage inflation and deflation.
Banks are financial institutions that accept deposits and grant loans. There are two main types of banks: commercial banks and central banks. Commercial banks accept deposits from the public and offer loans for consumption and investment purposes. Central banks act as the central authority that regulates the entire banking system of a country. Key functions of central banks include issuing currency, acting as a banker, agent and advisor to the government, overseeing commercial banks, acting as a lender of last resort, managing foreign exchange reserves, facilitating interbank clearing and settlement, and controlling the money supply to manage inflation and deflation.
3 Banks are that financial institution which accepts deposits and granting loan. Banks are of two types: 1. COMMERCIAL BANK A Commercial Bank is that financial institution which accepts deposits from the public and offers loan for the purpose of consumption and investment. eg. State Bank of India, Punjab Ntional Bank, ICICI, etc. Profits are generated by way of “Spread”. This refers to the difference between the rate at which they lend money and the Rate at which they borrow or accept deposits. Commercial banks Performs Two Primary Functions: (i) Accepting deposits: People can deposit their cash balance as: chequeable deposits and non-chequable deposits. (ii) Advancing loans: Banks are advancing loans mostly for productive purposes, against some approved securities as a source of funds for investment. Banks play the role of money creators or credit creators. There are four types of credit grant by a Commercial Banks (a) Cash Credit, (b) Overdraft (c) Term loan (d) Short-term loan. Credit Creation by Commercial Bank Commercial bank is an important source of money supply in the economy, which contribute to money supply by creating credit in terms of demand deposit. Suppose a new deposit of `1000 is made by a depositor into bank and Bank Legal Reserve Ratio is 10%. Bank will keep legal Reserve Ratio of `100 (10% of `1000) and lend the balance money of `900 to the borrower by crediting as chequable deposits (Ist round of credit creation). The borrower will use the amount to pay its creditors which ultimately will be deposited in another bank and bank keeps `90 (10% of `900) as legal Reserve Ratio and lends the balance `810 to borrower. (IInd Round of Credit Creation). This process will continue till amount become zero and make the money 10 times the initial deposits i.e. `10,000. 1 1 Deposit multipler (or) Money multiplier = = 10 times. LRR 10%
(39) BANKING 37
Credit Deposits Loans LRR
Creation Initial Deposit 1,000 900 100 Ist Round 900 810 90 IInd Round 810 729 81 All Other Round — — — Total 10,000 9,000 1,000
As seen in the table, banks are able to create total deposits of `10,000 with the initial deposits of just `1000. It means total deposits become 10 times of the initial deposit. This 10 times is value of Money Multiplier. 2. CENTRAL BANK (RBI) It is an apex bank that controls the entire banking system of a country. It is the sole agency of note issuing in a country. In India it is Reserve Bank, in England; Bank of England, in America; Federal Reserve System. Although, the first Central Bank in the world was set up in 1668 in Sweden, it was effective in 1694 with the establishment of Bank of England. RBI was established in April 1, 1935 under RBI Act passed in 1934. *Functions of Central Bank (i) Issuing Authority of Currency Notes: Central Bank of a country has the exclusive right of issuing notes. In 20th century, the Central Bank was known as Bank of Issue. Central Bank is the sole agency of issuing currency notes which is legal tender. However one rupee coin and notes are issued by Ministry of Finance. (ii) Banker of the Government: Central Bank is a banker, agent and financial advisor to the government As a banker to the government it manages accounts of the government As an agent to the government, it buys and sells securities on the behalf of the government It helps the government in framing policies to rgulate the Money Market. As a financial advisor, the Central Bank advises the government from time to time on economic financial and monetary matters. RBI also offers loans to the government against some securities. In situation of deficit government budget, the government often seeks loans from the Central Bank. This is called Deficit financing. (iii) “Bankers Bank” & “Supervisory Bank”: The Central Bank the banker’s bank and also plays a supervisory role. As a Banker’s Bank, it has almost the same relation with other banks in the country as a Commercial banks has with it’s customers. It accepts deposits from the Commercial Banks and offered them loans. The rate at which Central Bank offers loans to the Commercial Bank is called ‘Repo rate’. The rate at which commercial banks are allowed to park their surplus fund with RBI is called “Reverse Repo Rate”. 38 MACRO ECONOMICS
As a Supervisor, Central Bank Regulate and Controls the Commercial Banks.
RBI continuously exercised inspection on Commercial Banks. RBI gives license to Commercial Banks. Central Bank ensure that Commercial Banks maintains Cash Reserve Ratio & Statutory Liquidity Ratio in proper way. Otherwise RBI charge interest and penalty. (iv) Lender of the Last Resort: As we know, commercial bank create liabilities (demand deposits) many times more than their cash reserves. However, there may be occasions when a bank suffers crises of finance. In such a situation the Central Bank acts as a lender of last resort. Central Bank helps Commercial Banks in critical situation. (v) Custodian of Foreign Exchange Reserve: Central Bank is the custodian of nation’s foreign exchange reserve. The Central Bank not only maintain foreign exchange reserve but also exercises managed floating to ensure stability of exchange rate in the international money market. Managed floating refers to the sales and purchase of foreign exchange with a view to achieving stability of exchange rate for the domestic currency. (vi) Clearing house functon: Central Bank acts as a clearing house for transfer and settlement of mutual claims of Commercial Banks. Since the Central Bank hold reserves of Commercial Banks. It transfer funds from one Bank to other banks to facilitate clearing of cheques. (vii) Control of Credit: The most important function of the Central Bank is to control supply of money in the economy. It implies increase or decrease in the supply of money by regulatig the ‘Creating of Credit’ by the Commercial Banks. The Central Bank needs to control the supply of money to cope with the situation of inflation and deflation. During inflation, supply of money is restricted and during deflation, supply of money is liberalised. Measures to Control Inflation and Deflation: 1. Quantitative Measures. 2. Qualitative Measures. Quantitative Measures Qualitative Measures Instruments Instruments (i) Banks Rate and Repo Rate (i) Marginal Requirement
1. Quantitative Measures Quantitative instruments are traditional tools related to the Quantity or Volume of the money. These are also called general tools. It comprises of the following instruments. BANKING 39
(i) Bank Rate (or Discount Rate): It is the rate at which Commercial Banks borrow money from Central Bank to meet their long term needs. Repo Rate (or Repurchase rate): It is the rate at which Commercial Banks borrow money from Central Bank to meet their day to day requirement on short term basis. (Generally Repo Rate is lower than Bank Rate). To Control Inflation: RBI increase Bank Rate / Repo Rate as a follow- up action the Commercial Banks raise the rate of interest (the rate at which the Commercial Banks lend money to its depositors). This leads to decrease in demand for loans or credit. Consequently, consumption and investment expenditure are reduced. This process continue till Demand is equal to supply and inflation is controlled. To Control Deflation: RBI decrease Bank Rate / Repo Rate as a follow-up action the commercial reduce the rate of interest. This leads to increase in demand for loans or credit. Consequently, consumption and investment expenditure are increased. This process continue till demand is equal to supply and deflation is controlled. (ii) Legal Reserve Ratio: All Commercial Banks has to maintain legal Reserve Ratio. It is a legal obligation. Commercial Banks maintains reserves on two accounts. (a) Cash Reserve Ratio (CRR): It is a fix percentage of every initial deposit that all Commercial Banks have to hold as reserves with the Central Bank. (b) Statutory Liquidity Ratio (SLR): It is a fix percentage of every initial deposit that a Commercial Banks are required to maintain with themselves in form of cash, gold and government approved securities. To Control Inflation: RBI increase legal Reserve Ratio (CRR & SLR). This reduce their capacity to create credit. Reduction in credit leads to decrease in money supply in the economy accordingly amount of loan reduces and hence consumption and investment expenditure also reduce. This process continue till demand is equal to supply and inflation is controlled. To Control Deflation: RBI decreases legal Reserve Ratio (CRR & SLR). This increase their capacity to create more credit. Increase in credit leads to increase in money supply in the economy. Accordingly amount of loan increases and hence consumption and investment expenditure also increases. This process continue till demand is equal to supply and deflation is controlled. (iii) Open Market Operation: It refers to sale and purchase of government securities by Central Bank. To Control Inflation: RBI sell government securities to public, for making payment public withdraw money from Commercial Banks. This reduce the credit availability of Commercial Banks. So amount of credit or loans reduce in the market. Consequently consumption and investment expenditure will reduce. This process continues till demand is equal to supply and inflation is controlled. To control Deflation: RBI buys securities from public, public receives money in consideration and deposit the same in Commercial Banks. This raised 40 MACRO ECONOMICS
the credit availability of Commercial Banks. So amount of credit or loans are
increased in the market. Consequently consumption and investment expenditure also increases. This process continues till demand is equal to supply and deflation is controlled. (iv) Reverse Repo Rate: It is the rate at which Commercial Banks transfer its surplus money to a non-current A/c with RBI for earning income on idle funds. To Control Inflation: RBI increase Reverse Repo Rate this induce the Commercial Banks to park more funds with the RBI to generate more interest income. This leads to decrease in money supply in the economy. Consequently consumption and investment expenditure will reduce. This process continues till demand is equal to supply and inflation is controlled. To Control Deflation: RBI decrease Reserve Repo Rate, this discourage the Commercial Banks to park their surplus funds with the RBI. This leads to increase in money supply in the economy. Consequently consumption and investment expenditure will increase. This process continues till demand is equal to supply and deflation is controlled. 2. Qualitative Measures These are those instrument which focus on selected sectors of the economy. They are used for discriminating between different uses of credit. This policy of credit control is also called ‘Policy of Selective Credit Control’. It comprise the following instruments. (i) Marginal Requirement: It is the difference between the Current Value of asset mortgaged or pledged and amount of loan taken. Marginal requirement = Value of Assets – Amount of loan To control inflation: Marginal requirement is raised. Higher marginal requirement implies lower the amount of loan. Accordingly demand decreases and this process continues till demand is equal to supply and inflation is controlled. To control deflation: Marginal requirement is reduced. Lower marginal requirement implies higher the amount of loan. Accordingly demand increases and this process continues till demand is equal to supply and deflation is controlled. (ii) Moral Suation: It refers to moral pressure on the Commercial Banks by the central bank to be liberal in lending during deflation and banks are adviced to restrict and selective loans in inflation except farmers. The Commercial Bank generally don’t ignore the advice of RBI. (iii) Credit Rationing: It means fixing of credit quotas for different business activities. To control inflation credit needs to be restricted. The Commercial Banks can’t exceed the quota limit while granting loans. To control deflation rationing of credit is withdrawn to increase money supply in the economy. BANKING 41
Difference between Commercial Bank & Central Bank
Commercial Bank Central Bank (i) Commercial Bank accepts (i) Central Banks accepts deposits deposits from public only. from all Commercial Bank and Government. (ii) It contributes to supply of (ii) It controls the credit in the eco- money through Credit creation. nomy, through Monetary policy (iii) It is not the custodian of foreign (iii) It is the custodian of foreign exchange reserve exchange reserve. (iv) It focus on profit maximisation. (iv) It focus on stability and growth. (v) It is not a currency issuing (v) It is a currency issuing authority. authority.
IMPORTANT QUESTIONS Q.1. Explain the components of legal Reserve Ratio and how inflation and deflation is controlled through this? Q.2. Explain in details all the function of Central Bank. Q.3. Explain the credit creation role of Commercial Bank with the help of a numerical example. Q.4. Differentiate between Commercial and Central Bank. Q.5. What is meant by a Central Bank? Why is it known as the apex body? Q.6. Explain ‘Banker to the Government’ function of Commercial Bank. Q.7. What are open market operations? What is their effect on availability of credit? Q.8. If total deposit created by Commercial Banks is ` 20,000 crores and the primary deposit is ` 2500 crores, what is the value of Money Multiplier and reserve ratio? Q.9. Explain the role of reverse repo rate in controlling credit creation. Q.10. If legal reserve ratio is 0.2 and new deposits are ` 1000, explain the process of money creation by the Commercial Banks.
