Banking – CBSE Notes for Class 12

Macro Economics
Introduction:

Commercial Bank And Credit Creation By Commercial Bank

1. Commercial bank is a financial institution which performs the functions of

accepting deposits from the public and making loans and investments, with the
motive of earning profit.
2. Process of money creation/deposit creation/credit creation by the commercial
banking system.
(a) Let us assume that the entire commercial banking system is one unit. Let us call
this one unit simply “banks’. Let us also assume that all receipts and payments in the
economy are routed through the banks. One who makes payment does it by writing
cheque. The one who receives payment deposits the same in his deposit account.
(b) Suppose initially people deposit Rs.1000. The banks use this money for giving
loans. But the banks cannot use the whole of deposit for this purpose. It is legally
compulsory for the banks to keep a certain minimum fraction of these deposits as
cash. The fraction is called the Legal Reserve Ratio (LRR). The LRR is fixed by the
Central Bank. It has two components. A part of the LRR is to be kept with the Central
bank and this part ratio is called the Cash Reserve Ratio. The other part is kept by
the banks with themselves and is called the Statutory Liquidity Ratio.
(c) Let us now explain the process, suppose the initial deposits in banks is Rs.1000
and the LRR is 10 percent. Further, suppose that banks keep only the minimum
required, i.e., Rs.100 as cash reserve, banks are now free to lend the remainder
Rs.900. Suppose they lend Rs.900. What banks do to open deposit accounts in the
names of the borrowers who are free to withdraw the amount whenever they like.
• Suppose they withdraw the whole of amount for making payments.
(d) Now, since all the transactions are routed through the banks, the money spent by
the borrowers comes back into the banks into the deposit accounts of those who
have received this payment. This increases demand deposit in banks by ?900. It is
90 per cent of the initial deposit. These deposits of Rs.900 have resulted on account
of loans given by the banks. In this sense the banks are responsible for money
creation. With this round, increased in total deposits are now Rs.1900 (=1000 +
900).
(e) When banks receive new deposit of ?900, they keep 10 per cent of it as cash
reserves and use the remaining Rs. 810 for giving loans. The borrowers use these
loans for making payments. The money comes back into the accounts of those who
have received the payments. Bank deposits again rise, but by a smaller amount of
Rs.810. It is 90 per cent of the last deposit creation. The total deposits now increase
to Rs.2710 (=1000 + 900 + 810). The process does not end here.
(f) The deposit creation continues in the above manner. The deposits go on
increasing round after round but Deposit Creation By Commercial Banks each time
only 90 per cent of the last round deposits. At the same time cash reserves go on
increasing, each time 90 per cent of the last cash reserve. The deposit creation
comes to end when the total cash reserves become equal to the initial deposit. The
total deposit creation comes to Rs.10000, ten times the initial deposit as shown in
the table.

It can also be explained with the help of the following formula:

3. Banks required to keep only a fraction of deposits as cash reserves Banks are
required to keep only a fraction of deposits as cash reserves because of the
following two reasons:
(a) First, the banking experience has revealed that not all depositors approach the
banks for withdrawal of money at the same time and also that normally they
withdraw a fraction of deposits.
(b) Secondly, there is a constant flow of new deposits into the banks. Therefore to
meet the daily demand for withdrawal of cash, it is sufficient for banks to keep only a
fraction of deposits as a cash reserve.
4. When the primary cash deposit in the banking system leads to multiple expansion
in the total deposits, it is known as money multiplier or credit multiplier.

Central Bank And Their Functions

1. The central bank is the apex institution of a country’s monetary system. The
design and the control of the country’s monetary policy is its main responsibility.
India’s central bank is the Reserve Bank of India.
2. Functions of Central Bank.
(a) Currency Authority:
(i) The central bank has the sole monopoly to issue currency notes. Commercial
banks cannot issue currency notes. Currency notes issued by the central bank are
the legal tender money.
(ii) Legal tender money is one, which every individual is bound to accept by law in
exchange for goods and services and in the discharge of debts.
(iii) Central bank has an issue department, which is solely responsible for the issue
of notes.
(iv) However, the monopoly of central bank to issue the currency notes may be
partial in certain countries.
(v) For example, in India, one rupee notes and all types of coins are issued by the
government and all other notes are issued by the Reserve Bank of India.
(b) Banker, Agent and Advisor to the Government: Central bank everywhere in
the world acts as banker, fiscal agent and adviser to their respective government.
(i) As Banker: As a banker to the government, the central bank performs same
functions as performed by the commercial banks to their customers.
• It receives deposits from the government and collects cheques and drafts
deposited in the government account.
• It provides cash to the government as resumed for payment of salaries and wages
to their staff and other cash disbursements.
• It makes payments on behalf of the government.
• It also advances short term loans to the government.
• It supplies foreign exchange to the government for repaying external debt or
making other payments.
(ii) As Fiscal Agent: As a fiscal agent, it performs the following functions :
• It manages the public debt.
• It collects taxes and other payments on behalf of the government.
• It represents the government in the international financial institutions (such as
World Bank, International Monetary Fund, etc.) and conferences.
(iii) As Adviser
• The central bank also acts as the financial adviser to the government.
• It gives advice to the government on all financial and economic matters such as
deficit financing, devaluation of currency, trade policy, foreign exchange policy, etc.
3. Banker’s Bank and Supervisor:
(a) Banker’s Bank: Central bank acts as the banker to the banks in three ways: (i)
custodian of the cash reserves of the commercial banks; (ii) as the lender of the last
resort; and (iii) as clearing agent.
(i) As a custodian of the cash reserves of the commercial banks, the central bank
maintains the cash reserves of the commercial banks. Every commercial bank has to
keep a certain percent of its cash reserves with the central bank by law.
(ii) As Lender of the Last Resort.
• As banker to the banks, the central bank acts as the lender of the last resort.
• In other words, in case the commercial banks fail to meet their financial
requirements from other sources, they can, as a last resort, approach to the central
bank for loans and advances.
• The central bank assists such banks through discounting of approved securities
and bills of exchange.
(ii) As Clearing Agent
• Since it is the custodian of the cash reserves of the commercial banks, the central
bank can act as the clearinghouse for these banks.
• Since all banks have their accounts with the central bank, the central bank can
easily settle the claims of various banks against each other simply by book entries of
transfers from and to their accounts.
• This method of settling accounts is called Clearing House Function of the central
bank.
(b) Supervisor
(i) The Central Bank supervises, regulate and control the commercial banks.
(ii) The regulation of banks may be related to their licensing, branch expansion,
liquidity of assets, management, amalgamation (merging of banks) and liquidation
(the winding of banks).
(iii) The control is exercised by periodic inspection of banks and the returns filed by
them.
4. Controller of Money Supply and Credit: Principal instruments of Monetary
Policy or credit control of the Central Bank of a country are broadly classified as:
(a) Quantitative Instruments or General Tools; and
(b) Qualitative Instruments or Selective Tools.
(a) Quantitative Instruments or General Tools of Monetary Policy: These are the
instruments of monetary policy that affect overall supply of money/credit in the
economy. These instruments do not direct or restrict the flow of credit to some
specific sectors of the economy. They are as under:
(i) Bank Rate (Discount Rate)
• Bank rate is the rate of interest at which central bank lends to commercial banks
without any collateral (security for purpose of loan). The thing, which has to be
remembered, is that central bank lends to commercial banks and not to general
public.
• In a situation of excess demand leading to inflation,
-> Central bank raises bank rate that discourages commercial banks in borrowing
from central bank as it will increase 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 households to increase their savings by
restricting expenditure on consumption.
-> Thus, expenditure on investment and consumption is reduced, which will control
the excess demand.
• In a situation of deficient demand leading to deflation,
-> Central bank decreases bank rate that encourages commercial banks in
borrowing from central bank as it will decrease the cost of borrowing of commercial
bank.
-> Decrease in bank rate makes commercial bank to decrease their lending rates,
which encourages borrowers from taking loans, which encourages investment.
-> Again low rate of interest induces households to decrease their savings by
increasing expenditure on consumption.
-> Thus, expenditure on investment and consumption increase, which will control the
deficient demand.
(ii) 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.
• These securities are pledged as a security for the loans.
• It is called Repurchase rate as this involves commercial bank selling securities
to RBI to borrow the money with an agreement to repurchase them at a later
date and at a predetermined price.
• So, keeping securities and borrowing is repo rate.
• In a situation of excess demand leading to inflation,
-> Central bank raises repo rate that discourages commercial banks in borrowing
from central bank as it will increase 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 households to increase their savings by
restricting expenditure on consumption.
-> Thus, expenditure on investment and consumption is reduced, which will control
the excess demand.
• In a situation of deficient demand leading to deflation,
-> Central bank decreases Repo rate that encourages commercial banks 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 households to decrease their savings by
increasing expenditure on consumption.
-> Thus, expenditure on investment and consumption increase, which will control the
deficient demand.
(iii) Reverse Repo Rate
• It is the rate at which the Central Bank (RBI) borrows money from commercial
bank.
• In a situation of excess demand leading to inflation, Reverse repo rate is increased,
it encourages the commercial bank to park their funds with the central bank to earn
higher return on idle cash. It decreases the lending capability of commercial banks,
which controls excess demand.
• In a situation of deficient demand leading to deflation, Reverse repo rate is
decreased, it discourages the commercial bank to park their funds with the central
bank. It increases the lending capability of commercial banks, which controls
deficient demand.
(iv) Open Market Operations (OMO)
• It consists of buying and selling of government securities and bonds in the open
market by Central Bank.
• 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.
• 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.
(v) 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 the SLR or Statutory Liquidity Ratio.
• Cash Reserve Ratio:
-> It refers to the minimum percentage of a bank’s total deposits, which it 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 reserves as a matter of law.
-> For example, if the minimum reserve ratio is 10% and total deposits of a certain
bank is Rs. 100 crore, it will have to keep Rs. 10 crore with the Central Bank.
-> In a situation of excess demand leading to inflation, Cash Reserve Ratio (CRR) is
raised to 20 per cent, the bank will have to keep Rs.20 crore with the Central Bank,
which will reduce the cash resources of commercial bank and reducing credit
availability in the economy, which will control excess demand.
-> In a situation of deficient demand leading to deflation, cash reserve ratio (CRR)
falls to 5 per cent, the bank will have to keep Rs. 5 crore with the central bank, which
will increase the cash resources of commercial bank and increasing credit availability
in the economy, which will control deficient demand.
(vi) The Statutory Liquidity Ratio (SLR)
• It refers to minimum percentage of net total demand and time liabilities, which
commercial banks are required to maintain with themselves.
• In a situation of excess demand leading to inflation, the central bank increases
statutory liquidity ratio (SLR), which will reduce the cash resources of commercial
bank and reducing credit availability in the economy.
• In a situation of deficient demand leading to deflation, the central bank decreases
statutory liquidity ratio (SLR), which will increase the cash resources of commercial
bank and increases credit availability in the economy.
• It may consist of:
-> Excess reserves
-> Unencumbered (are not acting as security for loans from the Central Bank)
government and other approved securities (securities whose repayment is
guaranteed by the government); and
-> Current account balances with other banks.
(b) Qualitative Instruments or Selective Tools of Monetary Policy: These
instruments are used to regulate the direction of credit. They are as under:
(i) Imposing margin requirement on secured loans
• Business and traders get credit from commercial bank against the security of their
goods. Bank never gives credit equal to the full value of the security. It always pays
less value than the security.
• So, the difference between the value of security and value of loan is called
marginal requirement.
• In a situation of excess demand leading to inflation, central bank raises marginal
requirements. This discourages borrowing because it makes people gets less credit
against their securities.
• 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.
(ii) Moral Suasion
• Moral suasion implies persuasion, request, informal suggestion, advice and appeal
by the central banks to commercial banks to cooperate with general monetary policy
of the central bank.
• In a situation of excess demand leading to inflation, it appeals for credit contraction.
• In a situation of deficient demand leading to deflation, it appeals for credit
expansion.
(iii) Selective Credit Controls (SCCs)
• 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.
• In a situation of excess demand leading to inflation, the central bank introduces
rationing of credit in order to prevent excessive flow of credit, particularly for
speculative activities. It helps to wipe off the excess demand.
• In a situation of deficient demand leading to deflation, the central bank withdraws
rationing of credit and make efforts to encourage credit.